Your company is considering two potential new investments: Project B and Project

Question

Your company is considering two potential new investments: Project B and Project C. Each is a four-year project. The forecast cash flows for each project are shown below. The projects are independent. You have analyzed the systematic risk of each project. Your analysis has determined that the beta for Project B is 0.55, and the beta for Project C is 1.75. The risk-free rate is 5.5% and the market risk premium is 6%. Which project or projects should be accepted?

A. Accept Project B. Reject Project C.

B. Accept Project C. Reject Project B.

C. Accept both projects.

D. Reject both projects.

Explanation / Answer

Answer: As per Capital Asset Pricing Model:-

Expected Return :- Risk Free Rate+(Market return- Risk free rate)*Beta

Where:- Market Risk premium = Market return – Risk free rate

Risk free rate = 5.5%

Risk Premium = 6%

Beta of project B = .55

Beta of project C = 1.75

Expected return:-

Project B= 5.5%+(6% * .55) = 5.5%+3.3% = 8.8%

Project C = 5.5%+(6%* 1.75) = 5.5%+10.5% = 16%

Decision = On the basis of CAPM, project C expected return 16% is higher than project B 8.8%. Hence project C should be accept and project B should be reject. Hence answer is part (B) Accept Project C.Reject Project B.

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