Question

Explain whether each firm should take the project??

Suppose two financed equity firms (1: Stark industries) and (2: Acme company), are considering the exact new project with a beta of 1. Project IRR is 9.8%. Stark industries beta is 1.2 and ACME company beta is 0.6. The expected market risk pemium is 6% and risk-free rate is 3%.

Answer 1

Stark industries:
Beta=1.2
Project IRR is 9.8%
The expected market risk premium is 6% and risk-free rate is 3%.
Cost of capital=Risk free rate + Beta*(Market risk premium)
Cost of capital=3%+1.2*6%
=0.03+0.072
=0.102 or 10.20%
IRR<Cost of capital, the project should be rejected.

Acme company
Beta=0.6
Project IRR is 9.8%
The expected market risk premium is 6% and risk-free rate is 3%.
Cost of capital=Risk free rate + Beta*(Market risk premium)
Cost of capital=3%+0.6*6%
=0.03+0.036
=0.066 or 6.60%

IRR>Cost of capital, the project should be accepted.