Question

Your company has a Beta of 1.75. a) If risk-free rates are 1% and the market has an expected return of 8%, what is your company’s expected return? b) Assuming they are all equity financed, should they undertake a project with a 12% IRR? Why or why not?

Answer #1

a.The expected return on the stock is calculated using the Capital Asset Pricing Model (CAPM)

The formula is given below:

Ke=Rf+b[E(Rm)-Rf]

where:

Rf=risk-free rate of return

Rm=expected rate of return on the market.

Rm-Rf= Market risk premium

b= Stock’s beta

Ke= 1% + 1.75*(8% -1%)

= 1% + 1.75*7%

= 1% + 12.25%

= 13.25%.

b.The company should not undertake a project with an IRR of 12% since it is lesser than the expected rate of return.

In case of any query, kindly comment on the solution.

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