Question

An all-equity firm is considering the following projects:

Project beta expected return
w .75 8.9%
x .90 10.8
y 1.15 12.8
z 1.45 13.9
The T-bill rate is 4 percent, and the expected return on the market is 11 percent.

a) which projects have a higher expected return than the firms 11 percent cost of capital?

b) Which projects should be accepted?

c) Which projects would be incorrectly accepted or rejected if the firm's overall cost of capital were used as a hurdle rate?

Answer 1

a)

Project Y and Project Z

b)

Project X and Project Y

c)

Project X and Project Z

Step-by-step explanation:

Apply the CAPM to calculate the required return for each project as followed:

Project W: 4% + 0.75 * (11%-4%) = 9.25%

Project X: 4% + 0.90 * (11%-4%) = 10.3%

Project Y: 4% + 1.15 * (11%-4%) = 12.05%

Project Z: 4% + 1.45 * (11%-4%) = 14.15%

So, for:

a)

Which projects have a higher expected return than the firms 11 percent cost of capital: Project Y 12.8% and Project Z 13.9% which are given.

b)

Project should be accepted is project that has expected returns higher than required return which is Project X and Project Y.

c)

Using the firm's overall cost of capital as a hurdle rate:

Project Z will be accepted which is incorrect because its Required returned is higher than its expected returns ( 14.15% > 13.9%)

Project X will be rejected which is incorrect because its Required returned is lower than its expected returns ( 10.3% < 10.8%).