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Cost of capital and capital investment decisions

Example 2

A well-diversified client has approached you and asked you to evaluate some
potential investment opportunities detailed below.

Investment opportunity

1 2 3 4

Expected return 8% 18% 13% 7%

Beta 0.6 1.7 1.2 0.3

The risk free rate is 4% and the market risk premium on the market portfolio is
expected to be 8%.

Required: Which should you recommend to your client?

(Select all that apply)

A Investment opportunity 1

B Investment opportunity 2

C Investment opportunity 3

D Investment opportunity 4

Solution

B and C

Investment opportunity

1 2 3 4

Expected return 8% 18% 13% 7%

CAPM Required 4 + (8× 4 + (8 × 4 + (8 × 4 + (8 ×
return 0.6) = 1.7) = 1.2) = 0.3) =
8.8% 17.6% 13.6% 6.4%

As the expected returns for opportunities 2 & 4 are greater than the required
return you should recommend these.

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