Suppose IBM is considering whether to undertake a project that has similar risk

Question

Suppose IBM is considering whether to undertake a project that has similar risk characteristics to the overall firm. The equity beta of IBM is 1.32, the risk free rate is 10%, and the return on market portfolio is 25%. Suppose too that the company’s total assets are $100 million, with debt at $40 million and value of its stock $60 million. Its debt is known to be risk free. Assume no taxes.

The rate of return the company will choose to evaluate the project is

1. 29.8%.
2. 21.88%.
3. 19.28%.
4. 16%.
5. 24.22%.

Explanation / Answer

Risk-free Rate = 10%
Return on Market Portfoli = 25%
Equity Beta = 1.32

Calculating Rate of Return (R E): RE = Rf + Beta (RM - Rf) RE = 10% + 1.32 (25% - 10%) RE = 0.10 + 1.32 * 0.15 RE = 0.10 + 0.198 RE = 0.298 (or) 29.8% Rate of Return (RE) = 29.8% Thus, the answer is option (1) 29.8%

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