Explanation:
First, we calculate the required return of the investment using the Capital Asset Pricing Model (CAPM): Given:
Next, we evaluate the overall risk tolerance using the company's coefficient of variation (CV). The CV is 10%, meaning that for every 1% of return, the company tolerates 0.1% of risk. Risk = Return CV Risk = 20% 0.10` = 2%
Therefore, the maximum acceptable risk for this required return is 2%. If the project's overall risk is 2% or less, it meets the enterprise risk management policy and should be accepted.
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Q.27 Jim Korner is considering an investment in a Textile company based in India. The investment is twice as risky as the market. Jim is not sure if the investment risk would be acceptable, given the overall enterprise risk management policy. He discusses the matter with his department head. His boss suggests four different alternatives to Jim, as she is not sure what needs to be done. If the market return is 12%, the risk-free rate is 4%, and the company's overall coefficient of variation is 10% (for 1% return the company undertakes 0.1% risk), which of the following four alternatives would be John's best option? If the project's overall risk is:
A
Higher than 2%, it should be accepted.
B
2% or less, it should be accepted.
C
1.2%, it should be rejected.
D
4.0% or less, it should be accepted.