3) Firmwide versus Project-Specific WACCs An all-equity firm is consider- ing th

Question

3) Firmwide versus Project-Specific WACCs An all-equity firm is consider- ing the projects shown below. The T-bill rate is 4 percent and the market risk premium is 7 percent. If the firm uses its current WACC of 12 per- cent to evaluate these projects, which project(s), if any, will be incorrectly rejected?

Project Expected Return Beta

a 8.0% .5

b 19.0 1.2

c 13.0 1.4

d 17.0 1.6

4) In 2000, the S&P 500 Index earned 29.1 percent while the T-bill yield was 5.9 percent. Does this mean the market risk premium was negative? Explain.

It would be greatly appreciated if any math could be show in equation style form so I can actually learn from this.

Explanation / Answer

3)

Projects A, B, and C,D with expected returns of 8%, 19%, and 13%and 17%, respectively, have higher returns than the firm’s 12% cost of capital.
Project A = .04 + .5(.12 - .04) = .08 < .08, so accept A.
Project B = .04+ 1.2(.12 - .04) = .136 < .19, so accept B.
Project C = .04 + 1.4(.12 - .04) = .152 > .13, so reject C
.Project D = .04+ 1.6(.12 - .04) = .168 < .17, so accept D.
Project C would be incorrectly rejected and Project A would be incorrectly accepted.

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