An all-equity firm is considering the projects shown as follows. The T-bill rate is 3 percent and the market risk premium is 6 percent. If the firm uses its current WACC of 12 percent to evaluate these projects, which project(s), if any, will be incorrectly rejected?
$$\begin{array} { c c }
\text { Project } & \text { Expected Return } & \text { Beta } \
\mathrm { A } & 9.0 \% &0.8\
\mathrm {~B} & 20.0 \% &1.2\
\mathrm { C } & 13.0 \% &1.4\
\mathrm { D } & 17.0 \%&1.5
\end{array}$$
A) Only Project A would be incorrectly rejected.
B) Both Projects A and C would be incorrectly rejected.
C) Projects A, B, and C would be incorrectly rejected.
D) None of the projects would be incorrectly rejected.

Question

An all-equity firm is considering the projects shown as follows. The T-bill rate is 3 percent and the market risk premium is 6 percent. If the firm uses its current WACC of 12 percent to evaluate these projects, which project(s), if any, will be incorrectly rejected?
$$\begin{array} { c c } 
\text { Project } & \text { Expected Return } & \text { Beta } \
\mathrm { A } & 9.0 \% &0.8\
\mathrm {~B} & 20.0 \% &1.2\
\mathrm { C } & 13.0 \% &1.4\
\mathrm { D } & 17.0 \%&1.5
\end{array}$$
A) Only Project A would be incorrectly rejected.
B) Both Projects A and C would be incorrectly rejected.
C) Projects A, B, and C would be incorrectly rejected.
D) None of the projects would be incorrectly rejected.

Quizplus · Accepted Answer

The correct cost of capital to evaluate these projects is the cost of equity, which can be calculated using the Capital Asset Pricing Model (CAPM) formula: $$r = r_f + \beta (r_m - r_f)$$ where $r_f$ is the risk-free rate (T-bill rate = 3%), $r_m - r_f$ is the market risk premium (6%), and $\beta$ is the project-specific beta. For each project:- Project A: $3\% + 0.8(6\%) = 7.8\%$- Project B: $3\% + 1.2(6\%) = 10.2\%$- Project C: $3\% + 1.4(6\%) = 11.4\%$- Project D: $3\% + 1.5(6\%) = 12\%$Using the firm's WACC of 12% to evaluate these projects would incorrectly reject Project A because its required return based on CAPM (7.8%) is less than its expected return (9.0%), making it a viable project. Projects B, C, and D have expected returns higher than their CAPM-required returns, so they would not be incorrectly rejected.

An All-Equity Firm Is Considering the Projects Shown as Follows