Nelson Enterprises, an all-equity firm, has a beta of 2.5. Nelson’s chief financial officer is evaluating a project with an expected return of 27% before any risk adjustment. The risk-free rate is 6%, and the market risk premium is 8%. The project being evaluated is riskier than Nelson’s average project, in terms of both its beta risk and its total risk. Which of the following statements is correct?
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The accept/reject decision depends on the firm’s risk-adjustment policy. If Nelson’s policy is to increase the required return on a riskier-than-average project to 4% over rs, then it should reject the project.
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The project should definitely be rejected because its expected return (before risk adjustments) is less than its required return.
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Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment.
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The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.
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Financial Management 4th Edition (Cengage)