Question

Assume that two companies are considering a new marketing project that requires the same initial investment in both and will give the same financial benefits to both companies throughout the life of the project. In fact, the IRR is 10.50% for both of them. If these companies have the following capital asset pricing models (CAPM), which company will reject the project?

Company A	Company B
Risk-free Rate = 1% Market Rate = 6% Beta = 2	Risk-free Rate = 2% Market Rate = 10% Beta = 1

		a. Company A (Stock )
		b. Company B (Stock)
		c. Both of them
		d. Neither of them

Answer 1

Required rate of return of company A = Risk Free rate + (Market Return - Risk Free rate) × Beta

= 1% + (6% - 1%) × 2

=1% + (5% × 2)

= 1% + 10%

= 11%

Required rate of return of company A is 11%.

Now,

Required rate of return of company B = Risk Free rate + (Market Return - Risk Free rate) × Beta

= 2% + (10% - 2%) × 1

=2% + (8% × 1)

= 2% + 8%

= 10%

Required rate of return of company B is 10%.

IRR of project is 10.50%. the company should choose project only if its IRR is more than its required rate of return. FOr company A, IRR is lower than its required rate of return,so company A cannot accept the project. For company B, IRR is higher than its required rate of return,so company B must accept the project.

So, Company B stock is correct answer.

Option(B) is correct answer.