Question

Watta Corporation is a debt-free company with a company beta of 1.30 at a time when the risk free rate is 2 percent and the market risk premium is 5 percent. Although the company has two divisions with different risk levels, the CFO is currently using the company’s overall WACC as the hurdle rate for all projects. Watta’s home furnishings division has a divisional beta of 0.75 and its ammunition division has a divisional beta of 1.5. The home furnishings division has identified two projects with expected returns of 5.50 percent and 8.4 percent. The ammunitions division has identified two projects with expected returns of 8.6 percent and 9.2 percent. Draw a graph of the security market line. On the same graph, include a line for the company’s WACC and place an “x” in the appropriate position on the same graph for each of the four projects. Using the CFO’s criteria, which of the projects will be accepted? Which of the projects should NOT be accepted if analyzed properly?

Answer 1

We plot the different project betas and expected rate of return on the graphs and we get the various points. To get the security market line we calculate the company wise expected rate of return and we know the company wise beta.

The formula for calculating the company wise expected rate of return is using CAPM: Expected rate of return = R_f + beta*(R_m-R_f) where Rf =2%, R_m-R_f = 5% and Beta = 1.3.= 2% + 1.3*5% = 8.5%. Based on this we draw the security market line.

From the security market line, we could see that Ammunition project1 and home furnishing project 1 have an expected rate of return which is below the overall expected rate of return of the company and hence these two projects are rejected