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?

Explanation / Answer

According to CAPM,

Expected return = Risk free rate + beta*risk premium

Project B:

Expected return = 5.5% + 0.55*6% = 8.80%

NPV = -50000 + 10000/(1+0.088)^1 + 15000/(1+0.088)^2 + 19000/(1+0.088)^3 + 20000/(1+0.088)^4 = $888.35

Project C:

Expected return = 5.5% + 1.75*6% = 16%

NPV = -40000 + 8000/(1+0.16)^1 + 12000/(1+0.16)^2 + 15000/(1+0.16)^3 + 24000/(1+0.16)^4 = -1320.64

NPV is positive for project B.

So accpet project B. reject project C

option A.

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