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Critique of an Investment Decision
An investment manager is evaluating two mutually exclusive projects, both requiring an initial investment of $100,000. The risk-free rate of return is 3%.
- Project Alpha: Expected to return $115,000 in one year. It is considered moderately risky, warranting a 5% risk premium.
- Project Beta: Expected to return $120,000 in one year. It is a high-risk venture, warranting a 12% risk premium.
The manager, aiming to maximize the return, discounts both projects' expected returns using only the 3% risk-free rate. They conclude that Project Beta is the superior choice because its calculated Net Present Value is higher under this method.
Critically evaluate the manager's analysis. Identify the fundamental error in their approach, calculate the correct Net Present Value for both projects, and provide a justified recommendation on which project the company should pursue.
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