If the managers used the firm's overall required return of 13%, it would be making an error in calculating the NPV of each of the four asset categories. The appropriate discount rates for these categories are 10%, 12%, 14% and 16%, respectively.

While the overall required rate of return of 13% is not useful as a discount rate for any of the four real asset categories, what might it be good for? This rate could be used to calculate the value of the total firm, i.e., discount total firm cash flows by 13%. You might want to perform this calculation to determine the most you could afford to pay to take over the firm, i.e., buy up all of the firm's equity. (If you paid this amount, what would be the NPV of your investment? Zero! Why?)

The key point is that managers should evaluate projects according to the risk of the project, not necessarily the overall required rate of return of the firm. Of course, if all of the firm's assets have approximately the same risk, they would all have the same required return, and this return would match the required return on the firm's stock.

If managers evaluate all of the firm's projects by the same overall firm required rate of return, we have the following problem:

E(r)

Region of

False Acceptance

E(rp) Overall Required Return

Region of

False Rejection

rf

beta

In the triangular region of false rejection, the firm is turning down projects that earn more than their required SML rate of return but less than the firm's overall required rate of return. Projects in this zone would be like evaluating asset categories A1 and A2 from the above example using the 13% overall required return instead of the 10% and 12% that are required given the betas of these asset categories.

Similarly, we should not evaluate asset categories A3 and A4 using 13%. There required

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