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A firm is deciding on whether to undertake an internal investment project with a return of...

A firm is deciding on whether to undertake an internal investment project with a return of 9%. The company beta is 1.3, the risk free rate is 2% and the market rate is 7%. Use CAPM to decide whether or not to undertake this investment. Clearly justify you answer. Following the analysis you are now told that the firm is both small and has a high book-to-market ratio. How might your advice change?

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Answer #1

Return on project = 9%

Required Return using CAPM Model = Rf + Beta(Rm-Rf)

= 2% + 1.3(7%-2%)

=8.5%

Since the return on project is higher than the required return, the project should be accepted.

If the firm is small and has a high book to market ratio, that means that the market value of the assets of the company is much higher than its book value.

Required return is calculated on book value of assets. In this case, the firm will want a higher return on book value so as to get a fair return on market value. The project might not be acceptable in this case.

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