Financial Risk Manager Part 2
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A company specializing in the production of packaging materials is evaluating a new project which has an expected Risk-Adjusted Return on Capital (RAROC) of 15%. For context, the current risk-free annual interest rate stands at 3%, while the anticipated return on the market is 11% per annum. The firm's equity beta is quantified at 1.8. The company employs a modified RAROC measure to decide whether to proceed with the project. Based on this information, what decision should the company make, and what is the justification for that decision?
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A
Reject the project because the adjusted RAROC is higher than the market expected excess return.
B
Accept the project because the adjusted RAROC is higher than the market expected excess return.
C
Reject the project because the adjusted RAROC is lower than the risk-free interest rate.
D
Accept the project because the adjusted RAROC is lower than the risk-free interest rate.
Explanation:
The company should reject the project because the adjusted RAROC (ARAROC) is lower than the risk-free interest rate. The ARAROC formula is RAROC minus the equity beta times the difference between the expected market rate of return and the risk-free rate. In this case, with a RAROC of 15%, a beta of 1.8, an expected market rate of return of 11%, and a risk-free rate of 3%, the ARAROC is calculated as follows:
ARAROC = 0.15 - 1.8 * (0.11 - 0.03) = 0.15 - 1.8 * 0.08 = 0.15 - 0.144 = 0.006 or 0.6%
Since the ARAROC of 0.6% is less than the risk-free rate of 3%, the project does not provide adequate compensation for the non-diversifiable systematic risk borne by the shareholders, assuming they hold a well-diversified portfolio. Therefore, based on the adjusted RAROC metric, the project should be rejected.
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