Question

3. (Ch 10] An all-equity firm is considering the projects shown in the table below. The T-bill rate is 2% and the market risk premium is 5.5%. If the firm uses its current (composite) WACC of 7% (which it should NOT do because the WACC ignores risk) to evaluate these projects, which project(s), if any, will be INCORRECTLY rejected, and which projects, if any, will be INCORRECTLY accepted? [HINT: A picture might help you.] Project Beta 0.15 A Expected Return 2.25% 6.00% 7.75% 0.5 1.2 1.4 13.0%

Answer 1

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ke - Microsoft Excel (Product Activation Failed) Add-Ins View - 2x Σ AutoSum : A Dr General Wrap Text Merge & Center - $ :.: Insert Delete Format % , Number Conditional Format Formatting as Table Styles Cell Styles File Home Insert Page Layout Formulas Data Review % Cut Calibri -11AA = = = Ea Copy Paste Format Painter BI U D- DA Clipboard Font LT380 LM LN LO LP LQ 380 Rf = 2%, Rm-Rf=5.5% Fill 2 Clear Sort & Filter Editing Find & Select Alignment Cells LR LS LT LU LV LW LE 381 382 PROJECT 383 384 385 BETA REQUIRED RETURN = Rf + BETA(Rm-Rf) 0.15 2.83% 2% +0.15*(5.5%) 0.5 4.75% 8.60% 9.70% 386 387 388 389 390 A PROJECT WACC BASIS LOWER EXPECTED RETURN (2.25%) THAN COST OF CAPITAL (7%) B LOWER EXPECTED RETURN (6%) THAN COST OF CAPITAL (7%) HIGHER EXPECTED RETURN (7.75%) THAN COST OF CAPITAL(7%) HIGHER EXPECTED RETURN (13%) THAN COST OF CAPITAL (7%) DECISION REJECT REJECT ACCEPT ACCEPT 391 с 392 393 394 395 396 REQUIRED RETURN BASIS PROJECT EXPCECTED RETURN 2.25% 6.00% 7.75% 13.00% 397 VA VA REQUIRED RETURN 2.83% 4.75% 8.60% 9.70% DECISION REJECTED ACCEPTED REJECTED ACCEPTED 398 C 399 100 K M convexity DGM betaport future INDEX INTL CAP BUD SANDRINE LEASING PV, FV, ANNUITY DIR right clean KE CAPM UTILITY, SHARPE, beta ferences: CF493 YIELD bond portfolio BO! 120% * * WACC RI - O -_ Rea + D.E O ENG 27-11-2019

ke - Microsoft Excel (Product Activation Failed) Add-Ins File Home Insert Page Layout Formulas Data Review View - 2x % Cut Σ AutoSum : A Insert Delete Format Fill 2 Clear Sort & Filter Editing Find & Select Cells LU LV L W LYS 402 Calibri -11AA = = = Dr Wrap Text General E Copy Paste BI U Format Painter D- DA Merge & Center - $ % , Conditional Format :.: Cell Formatting as Table Styles Clipboard Font Alignment CD Number Styles LT412 LM LN LO LP LO - LR as LT LT 400D 401 IF COST OF CAPITAL IS USED AS HURDLE RATE, WHICH PROJECTS WRONGLY ACCEPTED OR REJECTED PROJECT DECISION 403 CORRECTLY REJECTED 404 INCORRECTLY REJECTED 405 INCORRECTLY ACCPTED 406 CORRECTLY ACCPTED 407 408 409 410 411 412 413 414 415 416 417 418 419 420 HIM Rea convexity DGM betaport future INDEX INTL CAP BUD SANDRINE LEASING PV, FV, ANNUITY DIR right clean KE CAPM UTILITY, SHARPE, beta ferences: CF493 YIELD bond portfolio WACC RI O BO! 120% - -_+ 19 * OENG 27-11-2019 2. B