A company has a 13% WACC. One of its core divisions is considering two mutually exclusive investments with the net cash flows given below. The division’s beta is βDIV = 1.45, risk free rate is kRF = 6.8% and risk-premium on the market is PRM =7%
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
A company has a 13% WACC. One of its core divisions is considering two mutually
exclusive investments with the net cash flows given below. The division’s beta is βDIV
= 1.45, risk free rate is kRF = 6.8% and risk-premium on the market is PRM =7%
| Year | Project A | Project B |
| 0 | -$1000 | -$1000 |
| 1 | $200 | $800 |
| 2 | $700 | $600 |
| 3 | $600 | $250 |
| 4 | $800 | $150 |
| 5 | -$300 | $170 |
| 6 | $250 | $150 |
Given the information above, you are required to answer the followings:
v. From your answers to Parts a, b, c and d, which project would be selected?
vi. What is each project’s profitability index
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