Answer to Question #61264 in Finance for Alex
Status of the probability return on return on proposed
Economy of existing portfolio investment
A 0.2 16% 12 %
B 0.4 18% 11 %
C 0.2 20% 10 %
D 0.1 22% 9%
E 0.1 24% 8%
The risk free rate of interest is 9%p.a.
a) Determine whether the proposed project is acceptable. (10 Marks)
b) Explain to Mr Maneno on the usefulness of CAPM in project appraisal.
( 5 Marks)
Economy A = 9 + (16 - 9)*0.2 = 10.4%, not accepted.
Economy B = 9 + (18 - 9)*0.4 = 12.6%, accepted.
Economy C = 9 + (20 - 9)*0.2 = 11.2%, accepted.
Economy D = 9 + (22 - 9)*0.1 = 10.3%, accepted.
Economy E = 9 + (24 - 9)*0.1 = 10.5%, accepted.
Overally the project is acceptable.
b) The usefulness of CAPM in project appraisal is explained by the next reasons:
1) It considers only systematic risk, reflecting a reality in which most investors havediversified portfolios from which unsystematic risk has been essentially eliminated.
2) It generates a theoretically-derived relationship between required return and systematicrisk which has been subject to frequent empirical research and testing.
3) It is generally seen as a much better method of calculating the cost of equity than thedividend growth model (DGM) in that it explicitly takes into account a company’s levelof systematic risk relative to the stock market as a whole.
4) It is clearly superior to the WACC in providing discount rates for use in investmentappraisal.
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