Assume you are the director of capital budgeting for an all-equity firm. The firm's current cost of equity is 16 percent; the risk-free rate is 10 percent; and the market risk premium is 5 percent. You are considering a new project that has 50 percent more beta risk than your firm's assets currently have, i.e., its beta is 50 percent larger than the firm's existing beta. The expected return (IRR) on the new project is 18 percent. Should the project be accepted if beta risk is the appropriate risk measure?
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A. B. C. D. E.C
Calculate the beta of the firm, and use to calculate project beta: k(s) = 0.16 = 0.10 + (0.05)b. b = 1.2. b(Project) = b(Firm)1.5 b(Project) is 50% greater than current b(Firm) b(Project) = (1.2)1.5 = 1.8.
Calculate required return on project, k(Project), and compare to IRR.
Project: k(Project) = 0.10 + (0.05)1.8 = 0.19 = 19%. IRR = 0.18 = 18%.
Since the required return is one percentage point greater than the expected IRR, the firm should not accept the new project.