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ACCA Applied Skills · Financial Management · Adjusting for risk and uncertainty in investment appraisal

A company's normal cost of capital is 10%. A project has a higher business risk than the company's existing operations, so management adds a 4% risk premium and discounts at 14%. The project's cash flows are: outlay $100,000 now, then $60,000 at the end of years 1 and 2. Discount factors at 14%: year 1 0.877, year 2 0.769. What is the NPV at the risk-adjusted rate?

The NPV at 14% is negative $1,240. Present value of inflows is $60,000 multiplied by 1.646, giving $98,760, and deducting the $100,000 outlay leaves a deficit, so the project would be rejected on the risk-adjusted rate.

  1. A$8,760Correct
  2. B$98,760
  3. C$(1,240)
  4. D$18,760

Explanation

PV of inflows = 60,000 × (0.877 + 0.769) = 60,000 × 1.646 = $98,760. NPV = 98,760 − 100,000 = −$1,240. Wait: this is negative, so the correct figure is $(1,240). Using 14% the project is rejected.

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