Question: Assume CAPM holds and you have the following information regarding three investment opportunities:
Project 1 has a project beta of 2.0 and you have estimated that the project's NPV using a cost of capital of 20% equals zero. Project 2 has a project beta of 1.5 and its NPV using a cost of capital of 10% equals zero. Lastly, project 3 has a project beta of 1.0 and its NPV equals zero using a cost of capital of 6%. None of these projects are ‘scale-enhancing' for the firm, i.e. they are different than the regular operations the firm currently maintains. As the head of the capital budgeting department you are trying to decide which projects should be accepted. The company has a levered equity beta of 0.8 and a debt-to-equity ratio of 0.5, which the company is planning to maintain for the foreseeable future. The company currently faces a 40% tax rate. Given that the expected return on the market portfolio is 8% and the risk-free rate is 3%, which projects would you accept and why? (Assume there is no capital rationing and the projects are going to be financed with 100% equity.)