Question

An all-equity firm is considering the following projects:

Answer 1

Answer:

a)

Project Y and Project Z

b)

Project X and Project Y

c)

Project X and Project Z

Explanation:

Apply the CAPM to calculate the required return for each project as followed:

Project W: 4% + 0.75 * (11%-4%) = 9.25%

Project X: 4% + 0.90 * (11%-4%) = 10.3%

Project Y: 4% + 1.15 * (11%-4%) = 12.05%

Project Z: 4% + 1.45 * (11%-4%) = 14.15%

So, for:

a)

Which projects have a higher expected return than the firms 11 percent cost of capital: Project Y 12.8% and Project Z 13.9% which are given.

b)

Project should be accepted is project that has expected returns higher than required return which is Project X and Project Y.

c)

Using the firm's overall cost of capital as a hurdle rate:

Project Z will be accepted which is incorrect because its Required returned is higher than its expected returns ( 14.15% > 13.9%)

Project X will be rejected which is incorrect because its Required returned is lower than its expected returns ( 10.3% < 10.8%).