Question

A project under consideration has an internal rate of return of 13% and a beta of 0.4. The risk-free rate is 3%, and the expected rate of return on the market portfolio is 13%.

a. What is the required rate of return on the project? (Do not round intermediate calculations. Enter your answer as a whole percent.)

b. Should the project be accepted?

• Yes

• No

c. What is the required rate of return on the project if its beta is 1.50? (Do not round intermediate calculations. Enter your answer as a whole percent.)

d. Should the project be accepted?

Answer 1

Information provided:

Internal rate of return= 13%

Beta= 0.4

Risk free rate= 3%

Expected return on the market portfolio= 13%

a.The required return on the project is calculated using the Capital Asset Pricing Model (CAPM)

The formula is given below:

Ke=Rf+[E(Rm)-Rf]

Where:

Rf=risk-free rate of return which is the yield on default free debt like treasury notes

Rm=expected rate of return on the market.

Rm-Rf= Market risk premium

= Stock’s beta

Ke= 3% + 0.4*(13% - 3%)

     = 3% + 4%

     = 7%

b.Since the internal rate of return is higher than the required rate of return, the project should be accepted.

c.Ke= 3% + 1.50*(13% - 3%)

        = 3% + 15%

        = 18%.

d.Since the internal rate of return is lower than the required rate of return, the project should be rejected.

In case of any query, kindly comment on the solution.