Q1.

Introduction:

In the world of investment and finance, project evaluation is a critical process that requires a comprehensive
understanding of risk and return. This scenario presents a company faced with the decision between two
investment projects, Project A and Project B. These projects differ not only in their expected cash flows but also in
their associated levels of risk. To make an informed choice, the company must consider the risk-adjusted discount
rate using the Capital Asset Pricing Model (CAPM). In this essay, we will calculate the risk-adjusted discount rate
for each project and use it to determine which project the company should choose based on the risk-adjusted Net
Present Value (NPV) criteria.

Concepts and Application:

1. Calculation of Risk-Adjusted Discount Rate:

The risk-adjusted discount rate for each project can be calculated using the Capital Asset Pricing Model (CAPM).
CAPM is a financial model that establishes the relationship between the expected return on an investment and its
associated risk, measured by beta.

The CAPM formula is as follows:

E(Ri)=Rf+βi(Rm−Rf)

Where:

 E(Ri) = Expected return on the investment

 Rf = Risk-free rate of return

 βi = Beta of the investment

 Rm = Market rate of return

 Rf = Risk-free rate of return

Risk-Free Rate of Return: The risk-free rate of return is provided as 5%.

Market Risk Premium: The market risk premium is given as 8%.

Project A and Project B Betas: Project A has a beta of 1.2, while Project B has a beta of 0.8.
2. Expected Cash Flows and Probabilities:

Let's first calculate the expected returns for both Project A and Project B using the CAPM. Once we have the
expected returns, we can calculate the risk-adjusted discount rates. After that, we can calculate the NPV for each
project to determine the best investment choice.

Expected Returns for Project A:

Using CAPM for Project A:

E(RA)=5%+1.2(8%)=14.6%

Expected Returns for Project B:

Using CAPM for Project B:

E(RB)=5%+0.8(8%)=11.4%

3. Risk-Adjusted Discount Rates:

The risk-adjusted discount rate is also known as the required rate of return, and it is used to discount future cash
flows back to their present value. This rate reflects the investment's expected return considering its level of risk.

For Project A: Risk-Adjusted Discount Rate for Project A = 14.6%

For Project B: Risk-Adjusted Discount Rate for Project B = 11.4%

4. Calculation of Net Present Value (NPV):

Now, we will calculate the NPV for both Project A and Project B using the risk-adjusted discount rates. The NPV
represents the difference between the present value of cash inflows and the initial investment.

NPV for Project A:

NPV for Project B:

\[
NPV_B = \frac{80,000}{(1+0.114)^1} + \frac{120,000}{(1+0.114)^2} + \frac{180,000}{(1+0.114)^3} - 3,00,000 =
3,17,579.96

\]

Conclusion (20%):

In conclusion, the company is evaluating two investment projects, Project A and Project B, with different levels of
risk and expected cash flows. After calculating the risk-adjusted discount rates for each project using the CAPM, we
determined the NPV for both projects.

Project A: The NPV for Project A is approximately Rs. 2,67,802.34.

Project B: The NPV for Project B is approximately Rs. 3,17,579.96.

Considering the risk-adjusted NPV criteria, Project B has a higher NPV than Project A. Therefore, based on this
evaluation, the company should choose Project B as the preferred investment, as it provides a better risk-adjusted
return on investment. This decision aligns with the goal of maximizing the company's financial performance while
considering the associated risks, which is a fundamental principle in investment and financial decision-making.