Question

The T-bill rate is 4 percent and the expected return on the market is 12 percent.

a. What projects have a higher expected return than the firm’s 12.5 percent cost of capital?

b. Which projects should be accepted?

Project	Beta	IRR
W	0.80	10.2%
X	0.90	11.4%
Y	1.10	12.6%
Z	1.35	15.1%

Answer 1

Expected return=Risk free rate + Beta*(Market Return-Risk free rate)
In the question, T-bill refers to the risk free rate (that is 4%) and market return is 12%.

Part a:

Expected return of project W with beta of 0.8:
Expected return=4%+0.8*(12%-4%)
=4%+0.8*(0.08)
=4%+0.064
=0.104 or 10.40%

Expected return of project X with beta of 0.9:
Expected return=4%+0.9*(12%-4%)
=4%+0.9*(0.08)
=4%+0.072
=0.112 or 11.20%

Expected return of project Y with beta of 1.10:
Expected return=4%+1.1*(12%-4%)
=4%+1.1*(0.08)
=4%+0.088
=12.8%

Expected return of project Z with beta of 1.35:
Expected return=4%+1.35*(12%-4%)
=4%+1.35*(8%)
=4%+0.108
=0.148 or 14.80%

Project Y and Z have higher expected return than the firm's 12.5 percent cost of capital.

Part b:
Projects with IRR greater than the cost of capital should be accepted.
The cost of capital here is 12.5% and IRR of projects Y and Z are greater than 12.5%. So, projects Y and Z should be accepted.