Question

17. SML and WACC [LO1] An all-equity firm is considering the following projects: Project Beta IRR W 8.9% X .85 .92 1.09 1.35 10.8 12.8 < 13.3 N The T-bill rate is 4 percent, and the expected return on the market is 11 percent. a. Which projects have a higher expected return than the firm's 11 percent cost of capital? b. Which projects should be accepted? c. Which projects would be incorrectly accepted or rejected if the firm's overall cost of capital were used as a hurdle rate?

Answer 1

Using CAPM equation, Expected return = Risk free rate + Beta*(Expected market return - Risk free rate),

We get following expected returns for each project

Project	Expected returns	IRR
W	9.95%	8.9%
X	10.44%	10.8%
Y	11.63%	12.8%
Z	13.45%	13.3%

a) Projects Z and Y have higher return than firm's 11% cost of capital

b) Project W and Z have more expected return than IRR and hence accepted

c) Project W have been incorrectly rejected (because its 9.95% expected return is below 11% cost of capital but above 8.9% IRR and project Y has been incorrectly accepted (because its 11.63% expected return is higher than 11% cost of capital but lower than 12.8% IRR)