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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.
(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.
(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.
(d) Outline alternative ways in which one might estimate the beta coefficient of a project.
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