An all-equity firm is considering the following projects: Project Beta IRR
W .85 8.9%
X .92 10.8
Y 1.09 12.8
Z 1.35 13.3
The T-bill rate is 4 percent, and the expected return on the market is 11 percent.
a. Which projects have a higher expected return than the firm's 11 percent cost of capital?
b. Which projects should be accepted?
c. Which projects would be incorrectly accepted or rejected if the firm's overall cost of capital were used as a hurdle rate?

Projects Y and Z

b. Projects W and Z

c. Projects W and Y

Explanation:

CAPM equation : Expected return = Risk free rate + Beta x (Expected market return - Risk free rate)

W = 4% + [0.85 x (11% - 4%)] = 9.95%

X = 4% + (0.92 x 7%) = 10.44%

Y = 4% + (1.09 x 7%) = 11.63%

Z = 4% + (1.35 x 7%) = 13.45%

Projects Y and Z have an expected return greater than 11%

b. Projects W and Z should be accepted because its expected return is higher than the IRR

c. Project W would be incorrectly rejected because the expected rate of return is less than the overall cost of capital (i.e. 9.95 is less than 11). But its expected rate of return is greater than the IRR

Y would be incorrectly accepted because its expected rate of return is greater  than the overall cost of capital but its expected rate of return is less than the IRR

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