A firm is considering two mutually exclusive projects, A and B. The projects are
different in that they have different returns depending on general economic conditions. The
firm forecasts that return on the market, and the returns on each project, along with their
associated probabilities will be given by the following table. You can assume a 5% risk free
rate and a 6% market risk premium. Assume the CAPM holds. Compare the expected
returns to the cost of capital for each project and decide which project the firm should choose.
Extreme Recession
Moderate Recession
Normal
Moderate Growth
Extreme Growth
Pr[economic condition]
15%
20%
30%
20%
15%
Return on the market
-12%
0%
12%
24%
36%
Return on project A
-35%
2%
10%
20%
20%
Return on project B
-9%
0%
12%
22%
28%
COST OF CAPITAL FOR PROJECT A ACROSS CONDITIONS =
COST OF CAPITAL FOR PROJECT B ACROSS CONDITIONS =
Which project should firm choose and why?