The directors of Holt plc have introduced a formal system of investment

appraisal. Projects must have a positive net present value when discounted at

a cost of capital determined in relation to their systematic risk. The board is

presently considering two unrelated projects. One is for an investment in a

speculative research project. This is fraught with potential problems because

it is dependent on the successful application of a recent theoretical discovery

reported in the physics literature. Even if the technical problems can be

overcome, there is a serious risk that another company will offer the principal

scientists — who are the leading specialists in their field — more lucrative

contracts. The other project is a rather more predictable expansion of the

production facilities for an existing product line which has a well established

market.

The beta coefficient for the research project is 0.6 while that of the new

production facilities is 1.3. The risk free rate is 3% and the risk premium is

8%.

(a) Calculate the required rate of return for each of the projects. [4]

(b) Explain why it might be possible that an apparently risky project could

have a lower required rate of return than that for a less volatile project.

[6]

(c) Explain whether company directors are likely to accept the logic

underlying the capital asset pricing model (CAPM) in practice when

they are making investment decisions. [5]

(d) Outline alternative ways in which one might estimate the beta

coefficient of a project.

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Status NEW Posted 06 Sep 2017 12:09 PM My Price 7.00

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