Explanation:
First, we need to establish the expected return of the investment using the Capital Asset Pricing Model (CAPM).
Since the project is twice as risky as the market, its Beta (β) is 2. Expected Return = Risk-Free Rate + β × (Market Return - Risk-Free Rate) Expected Return = 4% + 2 × (12% - 4%) = 4% + 16% = 20%
The company's overall coefficient of variation is 10% (meaning 0.1% risk is acceptable for every 1% of return, so Risk / Return = 0.10). Using this enterprise policy, the maximum acceptable risk for this project with an expected return of 20% is: Maximum Risk = 20% × 0.10 = 2%
Therefore, for the investment to be acceptable under the company's risk management policy, the project's overall risk must be 2% or less.
Ultimate access to all questions.
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.
No comments yet.