Q1. Company Risk versus Project Risk

Both Dow Chemical Company, a large natural gas user, and Superior Oil, a major natural gas producer, are thinking of investing in natural gas wells near Houston. Both are all-equity financed companies. Dow and Superior are looking at identical projects. They have analyzed their respective investments, which would involve a negative cash flow now and positive expected cash flows in the future. These cash flows would be the same for both firms. No debt would be used to finance the projects. Both companies estimate that their projects would have a net present value of $1 million at an 18 percent discount rate and a -$1.1 million NPV at a 22 percent discount rate. Dow has a beta of 1.25 whereas Superior has a discount rate of .75. The expected risk premium on the market is 8 percent and risk-free bonds are yielding 12 percent. Should either company proceed? Should both? Explain.

Q2. Beta

What factors determine the beta of a stock? Define and describe each.

How is beta used in the Capital Asset Pricing Model?