How do most firms deal with the risks of projects when making capital budgeting decisions?
A)Projects risks are not considered directly because the weighted average cost of capital (WACC) that is used as the required rate of return for capital budgeting decisions is based on the riskiness of the firm.As a result, all projects, no matter their risks, can be evaluated using WACC.
B)Evaluating risk is important only when the projects are similar to the firm's existing assets.
C)Most firms adjust the discount rates used to evaluate new projects that have significantly different risks than the risk associated with the firm's existing assets.
D)Firms generally increase the required rate of return used to evaluate projects that have significantly different risks than the risk associated with the firm's existing assets, regardless of whether the new projects' risks are higher or lower.
E)None of the above is a correct answer.

Question

Quizplus · Accepted Answer

Most firms adjust the discount rates used to evaluate new projects that have significantly different risks than the risk associated with the firm's existing assets. This allows for a more accurate evaluation of the project's potential return and helps to account for potential risks. Option A is incorrect because while the WACC is based on the firm's riskiness, it does not incorporate project-specific risks. Option B is incorrect because risk evaluation is important for all projects, not just those similar to existing assets. Option D is incorrect because simply increasing the required rate of return does not account for the specific type and level of risk associated with the project.

How Do Most Firms Deal with the Risks of Projects