Reference no: EM132456281

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%.

Question 1: Calculate the required rate of return for each of the projects.

Question 2: 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.

Question 3: 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.

Question 4: Outline alternative ways in which one might estimate the beta coefficient of a project.