Financial Risk Manager Part 2
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A company specializing in the production of packaging materials is considering undertaking a new project. The project is expected to deliver a Risk-Adjusted Return on Capital (RAROC) of 12%. Key financial data relevant to the decision includes an annual risk-free rate of 4%, a market's expected rate of return of 10% per annum, and an equity beta of 1.5 for the firm's stock. The company uses the modified RAROC measure to evaluate its potential projects. Based on this information, what decision should the company make concerning this project, and what is the justification for this decision?
A company specializing in the production of packaging materials is considering undertaking a new project. The project is expected to deliver a Risk-Adjusted Return on Capital (RAROC) of 12%. Key financial data relevant to the decision includes an annual risk-free rate of 4%, a market's expected rate of return of 10% per annum, and an equity beta of 1.5 for the firm's stock. The company uses the modified RAROC measure to evaluate its potential projects. Based on this information, what decision should the company make concerning this project, and what is the justification for this decision?
Explanation:
The company should reject the project because the adjusted RAROC is lower than the risk-free rate. The adjusted RAROC is calculated by subtracting the risk premium of the project from the RAROC. The risk premium is the product of the equity beta (βe), the expected market rate of return (Rm), and the risk-free rate of interest (Rf). In this case, the adjusted RAROC is calculated as follows:
Adjusted RAROC = RAROC - βe * (Rm - Rf) Adjusted RAROC = 12% - 1.6 * (10% - 4%) Adjusted RAROC = 12% - 1.6 * 6% Adjusted RAROC = 12% - 9.6% Adjusted RAROC = 2.4%
Since the adjusted RAROC of 2.4% is less than the risk-free rate of 4%, the project does not compensate the shareholders for the non-diversifiable systematic risk they bear when investing in the activity. Therefore, based on the adjusted RAROC metric, the project should be rejected.