A firm is considering the purchase of an asset whose stand-alone risk is greater than the average risk of its existing portfolio of assets. In evaluating this asset, the decision maker should:
A)increase the internal rate of return (IRR) used to evaluate the asset to reflect its higher risk.
B)increase the asset's net present value (NPV) to reflect its higher risk.
C)reject the asset because its acceptance would clearly decrease the value of the firm.
D)ignore the asset's higher risk if, after purchase, it will make up only a small fraction of the firm's total assets.
E)increase the required rate of return that is used to evaluate the asset to reflect its higher risk.

Question

Quizplus · Accepted Answer

When evaluating an asset whose stand-alone risk is greater than the average risk of the firm's existing portfolio, the decision maker should increase the required rate of return used to evaluate the asset to reflect its higher risk. By increasing the required rate of return, the net present value of the asset will decrease, reflecting the added risk. This ensures that the asset's return is commensurate with the risk taken on by the firm. Ignoring the higher risk or increasing the internal rate of return used to evaluate the asset would not address the issue of risk and could lead to incorrect investment decisions. Rejecting the asset outright is not necessarily the best choice since it may still provide value to the firm even with its higher risk.

A Firm Is Considering the Purchase of an Asset Whose