Table 12.3
Tangshan Mining Company is considering investment in one of two mutually exclusive projects M and N which are described below. Tangshan Mining's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Tangshan estimates that the beta for project M is 1.20 and the beta for project N is 1.40.
-Which of the following statements is most correct?
A) Because a business firm can be viewed as a portfolio of assets, it is important that the firm maintain a diversified portfolio of investments in order to reduce firm diversifiable risk.
B) Firm's are rewarded for choosing and implementing from among a diversifiable collection of projects through higher stock values.
C) Firms generally are not rewarded for choosing and implementing from among a diversifiable collection of projects through higher stock prices.
D) Two of the above are true.

Question

Table 12.3
Tangshan Mining Company is considering investment in one of two mutually exclusive projects M and N which are described below. Tangshan Mining's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Tangshan estimates that the beta for project M is 1.20 and the beta for project N is 1.40. 
-Which of the following statements is most correct?
A) Because a business firm can be viewed as a portfolio of assets, it is important that the firm maintain a diversified portfolio of investments in order to reduce firm diversifiable risk. 
B) Firm's are rewarded for choosing and implementing from among a diversifiable collection of projects through higher stock values. 
C) Firms generally are not rewarded for choosing and implementing from among a diversifiable collection of projects through higher stock prices. 
D) Two of the above are true.

Quizplus · Accepted Answer

The CAPM suggests that the expected return of an investment is determined by its beta and the market risk premium. As the market risk premium is the same for both projects, the project with the higher beta (project N) will have a higher expected return. However, Tangshan's cost of capital is only 15 percent, which is below the expected return for both projects. Therefore, Tangshan should not invest in either project as they would not meet the cost of capital. The statements in options A and B are not directly related to the question and are not applicable in this scenario.

Table 12.3 Tangshan Mining Company Is Considering Investment in One of Two