Question

An all-equity firm is considering the following projects:

Project	Beta	IRR
A	0.75	8.4%
B	0.95.	12.6%
C	1.15	13.5%
D	1.32	14.5%
E	1.45	15.9%

The T-bill rate is 3 percent, and the expected return on the market is 12 percent.

a. Which projects have a higher expected return than the firm’s 13 percent cost of capital? (5 points)

b. Which projects should be accepted? Why? (5 points)

Answer 1

As per CAPM, required rate of return = Risk free Rate + Beta*(Market Return - Risk free Return)

a.Projects having a higher expected return than the firm’s 13 percent cost of capital are the projects with IRR higher than 13%

i.e. Project C, D and E

b.

Project	Required Return as per CAPM	IRR	Decision
A	9.75%	8.4%	Reject
B	11.55%	12.6%	Accept
C	13.35%	13.5%	Accept
D	14.88%	14.5%	Reject
E	16.05%	15.9%	Reject

Hence, projects B and C should be accepted because return on project is higher than the required return