A firm is considering two mutually exclusive projects, A and B. The projects are different in that
Question:
A firm is considering two mutually exclusive projects, A and B. The projects are
different in that they have different returns depending on general economic conditions. The
firm forecasts that return on the market, and the returns on each project, along with their
associated probabilities will be given by the following table. You can assume a 5% risk free
rate and a 6% market risk premium. Assume the CAPM holds. Compare the expected
returns to the cost of capital for each project and decide which project the firm should choose.
Extreme Recession | Moderate Recession | Normal | Moderate Growth | Extreme Growth | |
| Pr[economic condition] | 15% | 20% | 30% | 20% | 15% |
| Return on the market | -12% | 0% | 12% | 24% | 36% |
| Return on project A | -35% | 2% | 10% | 20% | 20% |
| Return on project B | -9% | 0% | 12% | 22% | 28% |
COST OF CAPITAL FOR PROJECT A ACROSS CONDITIONS =
COST OF CAPITAL FOR PROJECT B ACROSS CONDITIONS =
Which project should firm choose and why?
Expert Answer:
To determine which project the firm should choose we need to compute the expected returns and the cost of capital using the Capital Asset Pricing Model CAPM for both projects A and B and then compare ... View the full answer
