Question

Interest is compounded annually unless stated otherwise. Payments are at the end of the year unless stated otherwise. All bonds have a face value of $1000. Taxes are 0 unless specified otherwise.

2. A project has a beta of 1.3. The risk-free return is 2% and the return on the market is 12%. The project has an IRR of 14%.

a) If the firm’s cost of capital is 10%, will they take the project using the cost of capital?

b) Using the CAPM to determine project risk, will they take the project?

c) Which method is better for analyzing this project? Why?

Answer 1

IRR from project = 14%

(a) Firm's cost of capital = 10%

Therefore firm will take the project since IRR from the project is higher than firm's cost of capital

(b)

Required rate of returns from project as per CAPM = Risk free rate + Beta x (Market Return - Risk free rate)

Required rate of returns from project as per CAPM = 2% + 1.3 x (12%-2%)

Required rate of returns from project as per CAPM = 15%

Since IRR from project is less than the required return as per CAPM, firm won't under take the project

(c) It is better to analyze this project using CAPM.

Required return from the project as per CAPM is basis the risk involved in project (beta of the project)

Although firm's cost of capital is lower than project's IRR, firm must not accept the project since the risk involved in project is high; and firm must analyze the project basis the risk involved in it and not on the basis of cost of capital of firm

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