An all-equity firm is considering the following projects: The T-bill rate is 5.3

Question

An all-equity firm is considering the following projects: The T-bill rate is 5.3 percent, and the expected return on the market is 12.3 percent. Compared with the firm's 12.3 percent cost of capital, Project W has a (Click to select) expected return, Project X has a (Click to select) expected return, Project Y has a (Click to select) expected return, and Project Z has a (Click to select) expected return. Project W should be (Click to select) Project X should be (Click to select) Project Y should be (Click to select) and Project Z should be (Click to select) If the firm's overall cost of capital were used as a hurdle rate, Project W would be (Click to select) Project X would be (Click to select) Project Y would be (Click to select) and Project Z would be (Click to select)

Explanation / Answer

a. Expected Return = Risk Free Rate + Beta (Market Rate - Risk Free rate)

Project W = 5.30 + .65 * (12.30 - 5.30) = 9.85% , IRR = 9.50%

Project X = 5.30 + .74 * (12.30 - 5.30) = 10.48% , IRR = 10.7%

Project Y = 5.30 + 1.33 * (12.30 - 5.30) = 14.61% , IRR = 14.2%

Project Z = 5.30 + 1.44 * (12.30 - 5.30) = 15.38% , IRR = 17.3%

b. If the expected return of a project is higher than cost of capital it should be accepted. Accordingly,

Project W rejected

Project X rejected

  Project Y accepted

Project Z accepted

c. A project should be accepted if the IRR exceeds hurdle rate. As per this rule, if hurdle rate is 12.3%,

Project W rejected

Project X rejected

  Project Y accepted

Project Z accepted

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