Question

Assume the risk-free rate of interest is 5% and the expected return on the market is 12%. If you are evaluating a project with a beta of 1.3 and an IRR of 17%, and you draw the security market line (SML) to guide your decision, which of the following statements is true?

a.           The vertical intercept of the SML will be 7%.

b.           The project’s IRR of 17% falls on the SML.

c.           The project’s IRR of 17% falls below the SML and the project should be rejected.

d.           The project’s IRR of 17% falls above the SML and the project should be accepted.

e.           The expected return on the market will graph on the SML corresponding with the beta of 1.3.

Answer 1

SML Ret or CAPM Ret = Rf + Beta ( Rm - Rf )

Rf = Risk free ret
Rm = Market ret
Rm - Rf = Risk Premium
Beta = Systematic Risk

Particulars	Amount
Risk Free Rate	5.0%
Market Return	12.0%
Beta	1.3000
Risk Premium ( Rm - Rf)	7.00%

Beta Specifies Systematic Risk. Systematic risk specifies the How many times security return will deviate to market changes. SML return considers the risk premium for Systematic risk alone.Where as CML return considers risk premium for Total risk. Beta of market is "1".

SML Return = Rf + Beta ( Rm - Rf )
= 5 % + 1.3 ( 7 % )
= 5 % + ( 9.1 % )
= 14.1 %

Rf = Risk Free rate

As IRR > SML Ret ( 14.10%), IRR will be above the SML Line and Project will be accepted.

Option D is correct

Pls comment, if any further assistance is required.