An all-equity firm is considering the projects shown below. The T-bill rate is 4% and the market risk premium is 7%. If the firm uses its current WACC of 12% to evaluate these projects, which project(s), if any, will be incorrectly accepted or rejected?
A) Project A would be incorrectly rejected.
B) Both Projects A and C would be incorrectly rejected.
C) Project A will be incorrectly rejected and Project B would be incorrectly accepted.
D) None of the projects will be incorrectly accepted or rejecteD.Step 1: Find Project Required Returns using CAPM. Project A: 8.2%; Project B: 12.4%; Project C: 13.8%; Project D: 14.5%; Project A would be incorrectly rejected since its required return is only 8.2% given its risk and it is expected to return 9%. Project C would be incorrectly accepted since it should earn 13.8% given its risk.

Question

An all-equity firm is considering the projects shown below. The T-bill rate is 4% and the market risk premium is 7%. If the firm uses its current WACC of 12% to evaluate these projects, which project(s), if any, will be incorrectly accepted or rejected? 
A) Project A would be incorrectly rejected. 
B) Both Projects A and C would be incorrectly rejected. 
C) Project A will be incorrectly rejected and Project B would be incorrectly accepted. 
D) None of the projects will be incorrectly accepted or rejecteD.Step 1: Find Project Required Returns using CAPM. Project A: 8.2%; Project B: 12.4%; Project C: 13.8%; Project D: 14.5%; Project A would be incorrectly rejected since its required return is only 8.2% given its risk and it is expected to return 9%. Project C would be incorrectly accepted since it should earn 13.8% given its risk.

Quizplus · Accepted Answer

Using the CAPM, we can calculate the required return for each project as follows:

Project A: 4% + 1.2(7%) = 8.4%
Project B: 4% + 1.8(7%) = 16.6%
Project C: 4% + 2.1(7%) = 17.7%
Project D: 4% + 2.4(7%) = 20.2%

Comparing these required returns to the current WACC of 12%, we can see that Project A's required return is lower than the WACC, indicating that it is undervalued and should be accepted. Project C's required return is higher than the WACC, indicating that it is overvalued and should be rejected.

Therefore, the correct answer is C, as Project A will be incorrectly rejected (instead of accepted), and Project C will be incorrectly accepted (instead of rejected). Project B and D are correctly evaluated using the WACC.

An All-Equity Firm Is Considering the Projects Shown Below