Tutorial Chapter 2 Risk and Refinements in Capital Budgeting P12-9 Risk-adjusted discount rates: Basic Mayflower Interiors is considering investing in one of three mutually exclusive projects, X, Y, and Z. The firm's cost of capital, r, is 13.5% and the risk-free rate, Rp, is 10%. The firm has gathered the basic cash flow and risk index data for each project as shown in the following table. Project (j) X Y Z Initial investment (CFQ) -$16,500 -$13,000 -$21,000 Year (1) Cash inflows (CF) 1 $5,500 $6,500 $5,000 2 5,500 4,500 6,500 3 5,500 5,200 .7,500 4 5,500 2,200 11,500 Risk index (RI) 1.70 1.00 0.40 a. Find the net present value (NPV) of each project, using the firm's cost of capital. Which project is preferred in this situation? b. The firm uses the following equation to determine the risk-adjusted discount rate, RADR,, for each project j: = RADR, R+ [RI, X (r - Rp)] where RF = RI, === risk-free rate of return risk index for project j r = cost of capital Substitute each project's risk index into this equation to determine its RADR. c. Use the RADR for each project to determine its risk-adjusted NPV. Which project is preferable in this situation? d. Based on your answers in parts a and c, which project should the firm accept? Explain your answer.