A large firm is discontinuing an older product; thus some facilities are becoming available for other uses. The following table summarizes eight new projects that would use the facilities. Considering expected return and risk, which projects are good candidates? The firm believes it can earn 4% on

Question

A large firm is discontinuing an older product; thus some facilities are becoming available for other uses. The following table summarizes eight new projects that would use the facilities. Considering expected return and risk, which projects are good candidates? The firm believes it can earn 4% on a risk-free investment in government securities (labeled as Project F).

Project	IRR	StandardDeviation
1	13.1%	6.5%
2	12.0	3.9
3	7.5	1.5
4	6.5	3.5
5	9.4	8.0
6	16.3	10.0
7	15.1	7.0
8	15.3	9.4
F	4.0	0.0

Accepted Answer

Answering the question is far easier if we use Figure 10-7. Since a larger expected return is better, we want to select projects that are as “high up” as possible. Since a lower risk is better, we want to select projects that are as “far left” as possible. The graph lets us examine the trade-off of accepting more risk for a higher return.

First, we can eliminate Projects 4 and 5. They are dominated projects. Dominated alternatives are no better than another alternative on all measures and inferior on at least one measure. Project 4 is dominated by Project 3, which has a higher expected return and a lower risk. Project 5 is dominated by Projects 1, 2, and 7. All three have a higher expected return and a lower risk.

Second, we look at the efficient frontier. This is the blue line in Figure 10-7 that connects Projects F, 3, 2, 7, and 6. Depending on the trade-off that we want to make between risk and return, any of these could be the best choice.

Project 1 appears to be inferior to Projects 2 and 7. Project 8 appears to be inferior to Projects 7 and 6. Projects 1 and 8 are inside and not on the efficient frontier.

There are models of risk and return that can allow us to choose between Projects F, 3, 2, 7, and 6; but those models are beyond what is covered here.

Question 10.14: A large firm is discontinuing an older product; thus some fa...

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