Explanation:
The correct answer is C because the adjusted RAROC is calculated to be 2.4%, which is lower than the risk-free rate of 4%, indicating the project should be rejected.
The formula for adjusted RAROC is:
Adjusted RAROC = RAROC - β_E × (R_m - R_f)
Where:
Calculation: Adjusted RAROC = 0.12 - 1.6 × (0.10 - 0.04) = 0.12 - 1.6 × 0.06 = 0.12 - 0.096 = 0.024 = 2.4%
Since 2.4% < 4%, the project should be rejected.
The adjusted RAROC measures whether shareholders are adequately compensated for the systematic risk they bear. When adjusted RAROC is below the risk-free rate, it means the project doesn't provide sufficient compensation for the non-diversifiable risk, and shareholders would be better off investing in risk-free assets instead.
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A packaging materials manufacturer is considering a project that has an estimated RAROC of 12%. Suppose that the risk-free rate is 4% per year, the expected market rate of return is 10% per year, and the company's equity beta is 1.6. The manufacturer uses the adjusted RAROC metric as the criterion to decide whether or not to accept the project. Which of the following correctly describes the decision the company should make and the rationale for making that decision?
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 rate.
D
Accept the project because the adjusted RAROC is lower than the risk-free rate.