In a CAPM world, assume that the risk free rate is 5% and the market risk premium is 5%.
a. Draw the Security Market Line. Briefly discuss why a security’s beta is a better measure of its risk than the standard deviation of its returns.
b. A venture capitalist is considering whether to acquire a stake in any of the following fully equity financed startups. Each stake is expected to be sold after one year. The costs of each position, the estimated proceeds from the sale and the betas of each startup are given in the table below.
Startup Cost Expected proceeds from sale next year Beta
1 £10m £12m 1
2 £20m £26m 3
3 £30m £39m 6
Compute the internal rate of return (IRR) for each project and identify the points corresponding to each project on your diagram. Assuming that the projects are not mutually exclusive, which one(s) would you advise to take?
c. Suppose now that the venture capitalist estimates its cost of capital to be 22% and only takes projects with IRR above its cost of capital, rejecting all other projects. Would this approach be correct? Give reasons for your answer