A firm is considering a new project whose risk is greater than the risk of the firm's average project, based on all methods for assessing risk.In evaluating this project, it would be reasonable for management to do which of the following?
A) Increase the estimated NPV of the project to reflect its greater risk.
B) Reject the project, since its acceptance would increase the firm's risk.
C) Ignore the risk differential if the project would amount to only a small fraction of the firm's total assets.
D) Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.
E) Increase the estimated IRR of the project to reflect its greater risk.

Question

Quizplus · Accepted Answer

When evaluating a project with higher-than-average risk, management should increase the cost of capital used to evaluate the project to reflect its higher-than-average risk. This is because the cost of capital represents the minimum rate of return that investors and lenders require to invest in the project, and a project with higher risk would require a higher rate of return to compensate for the additional risk. Increasing the estimated NPV or IRR would not accurately reflect the higher risk of the project, while rejecting the project outright or ignoring the risk differential would not be a rational decision.

A Firm Is Considering a New Project Whose Risk Is