Problem:
Weatherall Enterprises has no debt or preferred stock it is an all-equity firm and has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than an average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT?
- The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return.
- 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.
- The accept/reject decision depends on the firm's risk-adjustment policy. If Weatherall's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project.
- Capital budgeting projects should be evaluated solely on the basis of their total risk.
- Thus, insufficient information has been provided to make the accept/reject decision.
- The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.
Note: Provide specific examples to support your answers.