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? $$\begin{array} { | l | l | l | }
\hline \text { Project } & \text { Expected Return } & \text { Beta } \
\hline \mathrm { A } & 9.0 \% & 0.8 \
\hline \mathrm { B } & 20.0 \% & 1.2 \
\hline \mathrm { C } & 13.0 \% & 1.4 \
\hline \mathrm { D } & 17.0 \% & 1.5 \
\hline
\end{array}$$
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? $$\begin{array} { | l | l | l | } 
\hline \text { Project } & \text { Expected Return } & \text { Beta } \
\hline \mathrm { A } & 9.0 \% & 0.8 \
\hline \mathrm { B } & 20.0 \% & 1.2 \
\hline \mathrm { C } & 13.0 \% & 1.4 \
\hline \mathrm { D } & 17.0 \% & 1.5 \
\hline
\end{array}$$
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

To determine if a project should be accepted or rejected, we need to compare its expected return with its required return. The required return is determined by the project's beta and the market risk premium, added to the risk-free rate. Using the given information:
Required return = 3% + 0.8(6%) = 7.8% for Project A
Required return = 3% + 1.4(6%) = 11.4% for Project C
However, the firm is using a WACC of 12%, which is higher than the required return for both Project A and Project C. This means that if the firm used the correct required return, both projects would have a positive net present value (NPV) and should be accepted. Therefore, only Project A would be incorrectly rejected. Projects B and D have expected returns that are already higher than the WACC, so they would not be incorrectly rejected.

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