Question

Watta Corporation is a debt-free company with a company beta of 1.30 at a time when the risk free rate is 2 percent and the market risk premium is 5 percent. Although the company has two divisions with different risk levels, the CFO is currently using the company’s overall WACC as the hurdle rate for all projects. Watta’s home furnishings division has a divisional beta of 0.75 and its ammunition division has a divisional beta of 1.5. The home furnishings division has identified two projects with expected returns of 5.50 percent and 8.4 percent. The ammunitions division has identified two projects with expected returns of 8.6 percent and 9.2 percent. Draw a graph of the security market line. On the same graph, include a line for the company’s WACC and place an “x” in the appropriate position on the same graph for each of the four projects. Using the CFO’s criteria, which of the projects will be accepted? Which of the projects should NOT be accepted if analyzed properly?

Answer 1