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Answer: Reject the project because the adjusted RAROC is lower than the risk-free interest rate.
The correct decision for the company is to reject the project. This is because the adjusted RAROC (ARAROC) is less than the risk-free interest rate. The ARAROC formula is given by ARAROC = RAROC - JBE*(Rm - Rt), where JBE 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 risk premium of the project is calculated as JBE*(Rm - Rt). The ARAROC is used to evaluate whether the shareholders are compensated for the non-diversifiable systematic risk they bear when investing in a project. If the ARAROC exceeds the risk-free rate, the project adds value and should be accepted. However, if the ARAROC is less than the risk-free rate, as in this case where ARAROC = 15% - 1.8*(11% - 3%) = 15% - 1.8*8% = 15% - 14.4% = 0.6%, which is less than the risk-free rate of 3%, the project should be rejected.
Author: LeetQuiz Editorial Team
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A packaging materials producer is evaluating a potential project that has a forecasted risk-adjusted return on capital (RAROC) of 15%. Given that the risk-free interest rate stands at 3% per annum, the expected market return is 11% per annum, and the company's equity beta is 1.8, the producer uses the modified RAROC metric to decide whether to proceed with the project.
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.
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