SML and WACC

SML and WACC – An all equity firm is considering the following projects:

Project	Beta	Expected Return
W	0.75	10.0%
X	0.90	10.2
Y	1.20	12.0
Z	1.50	15.0

The T – bill rate is 5 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 was used as a hurdle rate?

a. Projects have a higher expected return are : project Y and Z

b. After considering risk via CAPM:

E = R_F + β (R_M – R_F)

E(W) = 0.05 + 0.75 (0.11 – 0.05) = 0.095 = 9.5% < 10.0%, so accept project W

E(X) = 0.05 + 0.90 (0.11 – 0.05) = 0.104 = 10.4% > 10.2%, so reject project X

E(Y) = 0.05 + 1.20 (0.11 – 0.05) = 0.122 = 12.2% > 12.0%, so reject project Y

E (Z) = 0.05 + 1.50 (0.11 – 0.05) = 0.14 = 14% < 15.0%, so accept project Z

c. Project W would be incorrectly rejected, project Y would be incorrectly accepted.

 

Reference: Corporate Finance Book, Stephen A.Ross, Randolph W.Westerfield and Jeffrey Jaffe, Ninth Edition. Chapter 13, questions and problems  number 15 page 422 – 423.