Question

Innovative Technology Corporation (ITC) estimates its WACC at 13%. It is considering projects PX, PY, and PZ. The financial manager, Lori, estimates the expected returns on these projects to be respectively 16% for PX, 12% for PY, and 10.9% for PZ. She estimates the betas to be 1.9 for PX, 1.0 for PY, and 0.7 for PZ. She also estimates the expected return on the market to be 12% and the risk-free rate is 6%.

a) If ITC ignores project risk and uses the WACC as a cut-off rate for acceptance or rejection, which projects would be accepted and which projects would be rejected?

b) Considering risk, which projects should be accepted or rejected? Why?

c) Draw the SML line and plot Projects PX, PY, and PZ on the same graph. Does the graph verify your answers to Part b. Please use excel to draw the graph?

Show steps please

Answer 1

We have the following information:

Projects	PX	PY	PZ
expected return	16%	12%	10.90%
Beta	1.9	1	0.7
WACC	13%
Rf	6%
Rm	12%

Part A

In this expected return will be compared with WACC and the projects a greater expected return than WACC will be selected.

WACC is 13% and only project PX has greater return than WACC, therefore, project PX would be selected.

Part B

Here we first need to calculate required return using CAPM

Required return = Rf + (Rm- Rf) x beta

Required return (PX) = 6%+ (12%-6%) x 1.90

                                      = 17.40%

Required return (PY) = 6%+ (12%-6%) x 1

                                      = 12%

Required return (PX) = 6%+ (12%-6%) x 0.7

                                      = 10.20%

Project PY and PZ should be selected as it has higher or equal expected return that the required return.

Part C

SML line can be drawn using the CAPM equation

Required return = Rf + (Rm- Rf) x beta

Part C