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?

Question

Quizplus · Accepted Answer

When a project has a higher risk than the firm's average project, it is important to adjust the cost of capital used to evaluate the project to reflect the higher risk. This is because the cost of capital reflects the required return for investing in a project given its risks. If the risks of a project are greater than average, the cost of capital used to evaluate it should be higher to account for the increased risk. Increasing the NPV or IRR of the project would not be appropriate as these measures are based on cash flows and do not account for risk. Rejecting the project outright without any further analysis may be premature, especially if the project has the potential to generate significant returns. Ignoring the risk differential simply because the project is a small fraction of the firm's total assets can also be problematic since it does not account for the impact that the project could have on the firm's overall risk.

A Firm Is Considering a New Project Whose Risk Is