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 N 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 N is ________. (See Table 11.9)

Quizplus · Accepted Answer

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

R = Rf + β*(Rm - Rf)

Where:
R = Risk-adjusted discount rate
Rf = Risk-free rate (5%)
β = Beta of the project (1.40 for project N)
Rm = Market return (15%)

So, for project N:
R = 0.05 + 1.40*(0.15 - 0.05) = 0.19 or 19%

Next, we calculate the NPVs of each project using the risk-adjusted discount rate:
NPV M = -$100,000 + ($30,000/0.15)*(1 - 1/[(1+0.15)^3]) = $53,579
NPV N = -$125,000 + ($45,000/0.19)*(1 - 1/[(1+0.19)^3]) = $85,732

Therefore, the NPV of project N is $85,732, making it the better choice.

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