Write a 200 word response to the following discussion post According to the text

Question

Write a 200 word response to the following discussion post

According to the textbook, “Under the CAPM, the expected return on the stock can be written like the below.” (Ross, Westerfield, Jaffe, & Jordan 2018). 1. The risk-free rate, RF. 2. The market risk premium, RM ? RF. 3. The stock beta, ?. Dow cost of equity = 12% + 1.25 X 8% = 22% Superior cost of equity = 12% + 0.75 X 8% = 18% Since the discussion post stated that the projects would have a net present value of $1 million at an 18% discount rate and a -$1.1 million NPV at a 22% discount rate, Dow should not invest because of a negative NPV. However, Superior should invest with a positive NPV. Resources: Ross, S. A., Westerfield, R. W., Jaffe, J. F., & Jordan, B. D. (2018). Corporate Finance: Core Principles & Applications (5th ed.). McGraw-Hill Education.

Explanation / Answer

Greetings,

The post is correct prima facie. NPV of the projects is calculated using cost of capital which is weighted average of cost of equity and cost of debt. So in above post, if we assume that both the firms only have equity financing then it means that cost of capital = cost of equity. So above post seems correct.

Two firms will have the same market risk premium i e RM - RF. RF is also same for all the companies, but still cost of equity may vary due to different betas. Beta of Dow is 1.25 and beta of superior is 0.75. So the cost of equity of Dow is higher. Beta is always stock specific and it reflects changes in lreturns of a stock with respect to changes in the returns of the market index. It is more for cyclical stocks and less for non cyclical stocks.

So it is true that Dow should not invest in the project as it has higher cost of capital and eventually will have negative NPV. However superior can invest as it has positive NPV at lower cost of capital.

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