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Explanation:
Adj RAROC = RAROC - Beta (Rm-Rf)
Decision rule: Accept (reject) projects whose adjusted RAROC is greater (smaller) than Rf.
Adjusted RAROC = 13% - 1.5(14% - 6%) = 1%
Since 1% < 6%, the project should be rejected
A note on the formula used
Old mock exams and study material used a slightly different formula, i.e.
ARAROC = (RAROC - Rf) / Beta
In fact, both formulas will lead to the same decision, but there are conditions.
First case: ARAROC = (RAROC - Rf) / Beta => to be compared with Rm-Rf
Accept (reject) projects whose adjusted RAROC is greater (smaller) than (Rm - Rf).
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Q.3209 Henry Campbell is equity analyst at Four Brothers Financials. He is currently analyzing a new project for expanding in new markets. His calculated RAROC is 13%, the risk-free rate is 6%, the market return is 14%, the firm's required return on equity is 12%, and the firm's beta is 1.5. What is the ARAROC and should the project be accepted?
A
11%; accept.
B
5.5%; reject.
C
6.2%; accept.
D
1.0%; reject.