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Answer: Reject the project because the ARAROC is lower than the risk-free interest rate.
The correct answer is C: Reject the project because the ARAROC is lower than the risk-free interest rate. The explanation is based on the adjusted RAROC (ARAROC) formula for a project, which is calculated as ARAROC = RAROC - βe*(Rm - Rt). Here, RAROC is the risk-adjusted return on capital, βe is the equity beta of the firm, Rm is the expected market rate of return, and Rt is the risk-free rate of interest. The term βe*(Rm - Rt) represents the risk premium of the project. The ARAROC is used to evaluate a project by adjusting the RAROC for the systematic riskiness of the returns. If the project's ARAROC exceeds the risk-free rate, it indicates that the shareholders are compensated for the non-diversifiable systematic risk they bear when investing in the project, assuming they hold a well-diversified portfolio. In such a case, the project adds value and should be accepted. However, if the ARAROC is less than the risk-free rate, the project does not provide adequate compensation for the systematic risk, and it should be rejected. Given the values: - RAROC = 15% - βe = 1.8 - Rm = 11% - Rt = 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 calculated ARAROC of 0.6% is less than the risk-free rate of 3%, the project should be rejected according to the ARAROC criterion.
Author: LeetQuiz Editorial Team
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A manufacturer specializing in packaging materials is evaluating a new project that has a projected risk-adjusted return on capital (RAROC) of 15%. The financial environment provides a risk-free interest rate of 3% per annum and an anticipated market rate of return of 11% per annum. The firm has an equity beta of 1.8. Based on these parameters, determine whether the company should undertake the project by analyzing it through the adjusted risk-adjusted return on capital (ARAROC) metric.
A
Reject the project because the ARAROC is higher than the market expected excess return.
B
Accept the project because the ARAROC is higher than the market expected excess return.
C
Reject the project because the ARAROC is lower than the risk-free interest rate.
D
Accept the project because the ARAROC is lower than the risk-free interest rate.