CLOUDESDALE CORPORATION IS CONSIDERING A PROJECT THAT HAS AN ESTIMA...

7.

Cloudesdale Corporation is considering a project that has an estimated risk-adjusted return on capital

(RAROC) of 13%. Suppose that the risk-free rate is 3% per year, the expected market rate of return is 11% per

year, and the firm's equity beta is 1.3. Using the criterion of adjusted risk-adjusted return on capital

(ARAROC), Cloudesdale should:

a.

Reject the project because the ARAROC is higher than the market expected excess return.

b.

Accept the project because the ARAROC is higher than the market expected excess return.

c.

Reject the project because the ARAROC is lower than the market expected excess return.

d.

Accept the project because the ARAROC is lower than the market expected excess return.

Correct Answer: c

Rationale:

ARAROC = (RAROC – R

_f

) /

β

= (0.13 – 0.03) / 1.3 = 7.69%.

Market excess return = R

_m

– R

_f

= 0.11 – 0.03 = 8%.

As ARAROC < market excess return, the project should be rejected.

Section: Operational and Integrated Risk Management

Reference: Michel Crouhy, Dan Galai and Robert Mark, Risk Management

(New York: McGraw-Hill, 2001). Chapter 14,

Capital Allocation and Performance Measurement.

Learning Objective:

Compute the adjusted RAROC for a project to determine its viability.

2015 Financial Risk Manager (FRM®) Practice Exam