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 IRR of the project to reflect its greater risk.
B)Increase the estimated NPV of the project to reflect its greater risk.
C)Reject the project, since its acceptance would increase the firm's risk.
D)Ignore the risk differential if the project would amount to only a small fraction of the firm's total assets.
E)Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.

Question

Quizplus · Accepted Answer

The best choice in this scenario would be to increase the cost of capital used to evaluate the project to reflect its higher-than-average risk. This is because the cost of capital is the minimum rate of return that the firm needs to earn on the project to cover its cost of capital and generate a return for its investors. By increasing the cost of capital, the firm is effectively discounting the expected cash flows of the project at a higher rate, which reflects the increased riskiness of the project. This will lower the estimated NPV and IRR of the project, making it less attractive and more in line with the firm's risk profile. Options A, B, and D are not appropriate in this scenario, as they either overstate the returns of the project or ignore its risk differential. Option C is also not appropriate, as rejecting the project solely based on its risk would not be a rational decision without taking into account its potential benefits and costs.

Firm Is Considering a New Project Whose Risk Is Greater