Question

On-line Text Co. has four new text publishing products that it must decide on publishing to expand its services. The firm's WACC has been 17%. The projects are of equal risk, Beta of 1.6. The risk-free rate is 7% and the market rate is expected to be 12%. The projects expected returns are as follows:
Project W= 14%
Project X= 18%
Project Y= 17%
Project Z= 15%

What project(s) should be clearly rejected?

D. Reject Z
B. Reject Y and Z
A. Reject X and Y
C. Reject W

Answer 1

Answer:

C. Reject W

Explanation:

In this question, we apply the Capital Asset Pricing Model (CAPM) which is shown below:

Expected return = Risk-free rate of return + Beta × (Market rate -  Risk-free rate of return)

= 7% + 1.6 × (12%-7%)

= 7% + 1.6 × 5%

= 7% + 8%

= 15%

The Project W should be rejected as it gives only 14% expected return which is less than the derived expected return.