Table 11.9
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 NPV for project M is ________. (See Table 11.9)

Question

Table 11.9
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 NPV for project M is ________. (See Table 11.9)

Quizplus · Accepted Answer

To calculate the risk-adjusted discount rate for each project, we use the following formula:

Ra = Rf + β(Rm - Rf)

Where Ra is the risk-adjusted discount rate, Rf is the risk-free rate, Rm is the market return, and β is the beta for each project.

For project M:

Ra = 0.05 + 1.20(0.15 - 0.05) = 0.17 or 17%

For project N:

Ra = 0.05 + 1.40(0.15 - 0.05) = 0.19 or 19%

Now, we can calculate the NPV for each project using the risk-adjusted discount rate:

NPV(M) = -$400,000 + [$100,000/(1+0.17)^1] + [$200,000/(1+0.17)^2] + [$300,000/(1+0.17)^3] + [$150,000/(1+0.17)^4] + [$100,000/(1+0.17)^5]

NPV(M) = $122,970

NPV(N) = -$400,000 + [$150,000/(1+0.19)^1] + [$200,000/(1+0.19)^2] + [$250,000/(1+0.19)^3] + [$300,000/(1+0.19)^4] + [$200,000/(1+0.19)^5]

NPV(N) = $91,411

Therefore, project M has a higher NPV and would be the better choice.

Table 11.9 Tangshan Mining Company Is Considering Investment in One of Two