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) will be incorrectly rejected?
$$\begin{array} { c c r }
\text { Project } & \text { Expected Return } & \text { Beta } \
\text { A } & 10.0 \% & 0.9 \
\text { B } & 17.0 \% & 1.1 \
\text { C } & 12.5 \% & 1.4 \
\text { D } & 15.0 \% & 2.2
\end{array}$$
A) Project A
B) Projects B and C
C) Project D
D) Project B

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) will be incorrectly rejected?
$$\begin{array} { c c r } 
\text { Project } & \text { Expected Return } & \text { Beta } \
\text { A } & 10.0 \% & 0.9 \
\text { B } & 17.0 \% & 1.1 \
\text { C } & 12.5 \% & 1.4 \
\text { D } & 15.0 \% & 2.2
\end{array}$$
A) Project A
B) Projects B and C
C) Project D
D) Project B

Quizplus · Accepted Answer

The correct discount rate for each project should be calculated using the Capital Asset Pricing Model (CAPM), which is given by the formula: $$r = r_f + \beta (r_m - r_f)$$, where $r_f$ is the risk-free rate (T-bill rate), $\beta$ is the project's beta, and $r_m - r_f$ is the market risk premium. For each project:- Project A: $3\% + 0.9(6\%) = 8.4\%$- Project B: $3\% + 1.1(6\%) = 9.6\%$- Project C: $3\% + 1.4(6\%) = 11.4\%$- Project D: $3\% + 2.2(6\%) = 16.2\%$Using the firm's WACC of 12% to evaluate these projects will incorrectly reject Project A because its expected return of 10% is higher than its correct discount rate of 8.4% but lower than the WACC of 12%. Projects B, C, and D have expected returns higher than both their correct discount rates and the firm's WACC, so they would not be incorrectly rejected.

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