Table 12.3
Tangshan Mining Company is considering investment in one of two mutually exclusive projects M and N which are described below. Tangshan Mining's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Tangshan estimates that the beta for project M is 1.20 and the beta for project N is 1.40.
-Using the risk-adjusted discount rate method of project evaluation, the better investment for Tangshan Mining is ________. (See Table 12.3)
A) Project M because it has a higher NPV
B) Project N because it has a higher NPV
C) Project N because it has a higher IRR
D) Project M because it has a higher IRR

Question

Table 12.3
Tangshan Mining Company is considering investment in one of two mutually exclusive projects M and N which are described below. Tangshan Mining's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Tangshan estimates that the beta for project M is 1.20 and the beta for project N is 1.40. 
-Using the risk-adjusted discount rate method of project evaluation, the better investment for Tangshan Mining is ________. (See Table 12.3)
A) Project M because it has a higher NPV 
B) Project N because it has a higher NPV 
C) Project N because it has a higher IRR 
D) Project M because it has a higher IRR

Quizplus · Accepted Answer

The risk-adjusted discount rate method considers the project's beta to adjust the discount rate. The formula for the risk-adjusted discount rate is: 
Risk-adjusted discount rate = Risk-free rate + Beta x (Market rate of return - Risk-free rate)

For project M: 
Risk-adjusted discount rate = 5% + 1.20 x (15% - 5%) = 17%

For project N: 
Risk-adjusted discount rate = 5% + 1.40 x (15% - 5%) = 19%

Using these risk-adjusted discount rates, we can calculate the NPV and IRR for each project.

For Project M: 
NPV = -$35,627 
IRR = 9.27%

For Project N: 
NPV = $7,689 
IRR = 10.46%

Therefore, based on the risk-adjusted discount rate method, Project M has a lower NPV and IRR compared to Project N. Thus, the better investment for Tangshan Mining is Project N because it has a higher NPV.

Table 12.3 Tangshan Mining Company Is Considering Investment in One of Two