Question

An all-equity firm is considering the projects shown below. The T-bill rate is 4% and the expected market return is 14%. Using the CAPM, calculate the risk adjusted required return for each project. If the firm uses its current WACC of 12 percent to evaluate these projects, which project(s), if any, will be incorrectly rejected? Which project(s), if any, will be incorrectly accepted?

Project Expected Return Project Beta

A 10.0% 0.5

B 19.0% 1.2

C 13.0% 1.4

D 20.0% 2.5

CAPM: E(Ri) = RF + [Bi X (E(Rm) – Rf)]

Where; E(Ri) = expected return for project i.

RF = risk-free rate (T-bill rate)

Bi = Beta for project i.

E(Rm) = expected return for the market

Answer 1

Project A:

Risk adjusted required return = Risk free rate + beta (market return - risk free rate)

Risk adjusted required return = 4% + 0.5 (14% - 4%)

Risk adjusted required return = 4% + 5%

Risk adjusted required return = 9%

Project B:

Risk adjusted required return = Risk free rate + beta (market return - risk free rate)

Risk adjusted required return = 4% + 1.2 (14% - 4%)

Risk adjusted required return = 4% + 12%

Risk adjusted required return = 16%

Project C:

Risk adjusted required return = Risk free rate + beta (market return - risk free rate)

Risk adjusted required return = 4% + 1.4 (14% - 4%)

Risk adjusted required return = 4% + 14%

Risk adjusted required return = 18%

Project D:

Risk adjusted required return = Risk free rate + beta (market return - risk free rate)

Risk adjusted required return = 4% + 2.5 (14% - 4%)

Risk adjusted required return = 4% + 25%

Risk adjusted required return = 29%

Project C will be incorrectly accepted