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?
A) Increase the estimated IRR of the project to reflect its greater risk.
B) Reject the project, since its acceptance would increase the firm's risk.
C) Ignore the risk differential if the project would amount to only a small fraction of the firm's total assets.
D) Increase the cost of capital used to evaluate the project to reflect the project's higher-than- average risk.

Question

Quizplus · Accepted Answer

Since the project is riskier than the firm's average project, the cost of capital used to evaluate the project should be increased to reflect the higher-than-average risk. This is because the cost of capital represents the minimum return that investors require for investing in the project, and a riskier project requires a higher return to compensate for the increased risk. Increasing the estimated IRR or ignoring the risk differential would underestimate the true risk of the project, while rejecting the project solely based on risk would overlook the potential benefits of the project.

A Firm Is Considering a New Project Whose Risk Is