Laramie Labs uses a risk-adjustment when evaluating projects of different risk. Its overall (composite) WACC is 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Laramie evaluates low-risk projects with a risk-adjusted project cost of capital of 8%, average-risk projects at 10%, and high-risk projects at 12%. The company is considering the following projects: Which set of projects would maximize shareholder wealth?

A) A and B.
B) A, B, and C.
C) A, B, and D.
D) A, B, C, and D.
E) A, B, C, D, and E.

Question

Laramie Labs uses a risk-adjustment when evaluating projects of different risk. Its overall (composite) WACC is 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Laramie evaluates low-risk projects with a risk-adjusted project cost of capital of 8%, average-risk projects at 10%, and high-risk projects at 12%. The company is considering the following projects: Which set of projects would maximize shareholder wealth?

A) A and B. 
B) A, B, and C. 
C) A, B, and D. 
D) A, B, C, and D. 
E) A, B, C, D, and E.

Quizplus · Accepted Answer

To maximize shareholder wealth, Laramie Labs should choose projects with a higher net present value (NPV). Using the risk-adjustment approach, the project's discount rate is adjusted to reflect its risk level. Based on this approach, we can calculate the NPV for each project and compare them.

The NPV for each project is as follows:

Project A: NPV = -$5,000 + $2,000/1.08 = $1,018.52
Project B: NPV = -$50,000 + $20,000/1.08 = $10,185.18
Project C: NPV = -$150,000 + $75,000/1.10 = $20,454.55
Project D: NPV = -$200,000 + $120,000/1.12 = $11,785.71
Project E: NPV = -$400,000 + $200,000/1.12 = $23,571.43

Based on the NPV calculation, projects C, D, and E have a higher NPV than projects A and B. Therefore, projects A and B should be rejected, and projects C, D, and E should be accepted to maximize shareholder wealth. So, the best choice is C.

Laramie Labs Uses a Risk-Adjustment When Evaluating Projects of Different