Question

3

Consider the following projects, X and Y where the firm can only choose one. Project X costs $600 and has cash flows of $400 in each of the next 2 years. Project also costs $600 and generates cash flows of $500 for the next 2 years respectively. Which investment should the firm choose the cost of capital is 25 percent? 

Another since both the projects have negative NPV 

Another, since both the projects have positive NPV 

Project X sine X has a higher NPV than Y 

Project Y since Y has a higher NPV than X

4

Capital asset pricing model (CAPM) For the shown in the following table, use the capital asset pricing model to find the required return.

Answer 1

Answer to question 3

The correct answer is D. Project Y, since it has a higher NPV than Project X.

For mutually exclusive projects we need to select only one of them. When Net Present Value (NPV) of both the projects is positive then such project will be selected whose NPV is greater.

Generally while using NPV for decision making such project should be selected whose NPV is greater than zero. In case of negative NPV such project shall be rejected.

NPV = Present value of cash inflows - Initial Investment

Since the NPV of Project Y is greater, it should be selected over project X.

Note - How did we calculate discounting factors @25%

Year 1 - 1/1.25

= 0.8000

Year 2 - 0.8000 / 1.25

= 0.6400

Answer to question 4

As per Capital Asset Pricing Model (CAPM)

Re = Rf + (Rm-Rf) β

Where Re = Required rate of return

Rf = Risk free rate of return

Rm – Market Return or Expected Return on Market

β – Beta

Calculation of Required rate of return

Rm = 10 %

Rf = 4 %

β = 1.7

Using the formula Re = Rf + (Rm-Rf) β

Re = 4 + (10-4) 1.7

= 4 + 6 * 1.7

= 4 + 10.2

= 14.20 %

Therefore Required Rate of Return = 14.20%