An all-equity firm is considering the following projects: The T-bill rate is 4 p

Question

An all-equity firm is considering the following projects:

The T-bill rate is 4 percent, and the expected return on the market is 11 percent.

a. Compared with the firm's 11 percent cost of capital, Project W has a (Higher or lower) expected return, Project X has a (Higher or lower) expected return, Project Y has a (Higher or lower) expected return, and Project Z has a (Higher or lower) expected return.

b. Project W should be (accepted or rejected) , Project X should be (accepted or rejected), Project Y should be(accepted or rejected) , and Project Z should be (accepted or rejected) .

c. If the firm's overall cost of capital were used as a hurdle rate, Project W would be (incorrectly accepted/incorrectly rejected/correctly accepted/correctly rejected) , Project X would be (incorrectly accepted/incorrectly rejected/correctly accepted/correctly rejected , Project Y would be (incorrectly accepted/incorrectly rejected/correctly accepted/correctly rejected, and Project Z would be(incorrectly accepted/incorrectly rejected/correctly accepted/correctly rejected.

Please choose one option from each bracket.

.

Explanation / Answer

Using Capm Model Market Retrun = Risk Free rate + Beta * ( Market Return - Risk Free rate) =
Expected return of W = 4% + 0.6 * ( 11% -4%) = 8.2%
Expected return of X = 4% + 0.85 * ( 11% -4%) = 9.55%
Expected return of Y = 4% + 1.15 * ( 11% -4%) = 12.05%
Expected return of Z = 4% + 1.45 * ( 11% -4%) = 14.15%
a) Based on above calculation if expected return can be compared with 11% cost of capital
Project W has a ( lower) expected return, Project X has a ( lower) expected return, Project Y has a (Higher )expected return, and Project Z has a (Higher ) expected return.

b)If return > Cost of capital it is accepted else rejected
Project W should be ( rejected) , Project X should be (rejected), Project Y should be(accepted ) , and Project Z should be (accepted ) .

c) If the firm's overall cost of capital were used as a hurdle rate the IRR should be greater than cost of capital.
Project W would be (correctly rejected) , Project X would be(correctly rejected) , Project Y would be(correctly accepted), and Project Z would be(correctly accepted)

Best of Luck. God Bless

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