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

Question

Quizplus · Accepted Answer

When evaluating a project with higher-than-average risk, it is appropriate to adjust the cost of capital used to evaluate the project to reflect its higher risk. This is because the cost of capital represents the required return for the level of risk taken by the firm, and a higher risk project should have a higher required return. Option A and B are not appropriate as adjusting the estimated IRR or NPV would be manipulating the project's expected cash flows. Option C is too extreme and might result in missed opportunities for the firm. Option D is not appropriate as the size of the project is irrelevant when evaluating risk.

A Firm Is Considering a New Project Whose Risk Is