Like most firms in its industry, Yeastime Bakeries uses a subjective risk assessment tool of its own design. The tool is a simple index by which projects are ranked by level of perceived risk on a scale of 0-10. The scale is recreated in the following table.
|
Risk index
|
Required return
|
|
0
|
4.0% (current risk-free rate)
|
|
1
|
4.5
|
|
2
|
5.0
|
|
3
|
5.5
|
|
4
|
6.0
|
|
5
|
6.5 (current IRR)
|
|
6
|
7.0
|
|
7
|
7.5
|
|
8
|
8.0
|
|
9
|
8.5
|
|
10
|
9.0
|
The firm is analyzing two projects based on their RADRs. Project Sourdough requires an initial investment of $12,500 and is assigned a risk index of 6. Project Greek Salad requires an initial investment of $7,500 and is assigned a risk index of 8. The two projects have 7-year lives. Sourdough is projected to generate cash inflows of $5,500 per year. Greek Salad is projected to generate cash inflows of $4,000 per year. Use each project's RADR to select the better project.