Problem 7 Electron Wizards, Inc. (EWI) has a new idea for producing TV sets and it is planning to enter the devel- opment stage. Once the product is developed (which will be at the end of 1 year), the company expects to sell its new process for a price p. with expected value p = $24mil. However, this sale price will de- pend on the market for TV sets at the time. By examining the stock histories of various TV companies, it is determined that the final sales price p is correlated with the market return rM with ElrM E(p-p)(TM-TM )-$2Ornil . 21 where Thi is the variance of the market return rM To develop the process, EWI must invest in a research and development project. The cost c of this project will be known shortly after the project is begun (when a technical uncertainty will be resolved). The current estimate is that the cost will be either c-$20mil or c- S16mil and each of these is equally likely. (This uncertainty is uncorrelated with the final price and is also uncorrelated with the market.) Assume that the risk-free rate is 9% and the expected return on the market is M 33%. (a) What is the expected rate of return of this project? (b) What is the beta of this project? Hint: In this case, note thatErM-FM)-EE-rM) (c) Is this an acceptable project based on a CAPM criterion? In particular, what is the excess rate of return (+ or -) above the return predicted by the CAPM? Problem 7 Electron Wizards, Inc. (EWI) has a new idea for producing TV sets and it is planning to enter the devel- opment stage. Once the product is developed (which will be at the end of 1 year), the company expects to sell its new process for a price p. with expected value p = $24mil. However, this sale price will de- pend on the market for TV sets at the time. By examining the stock histories of various TV companies, it is determined that the final sales price p is correlated with the market return rM with ElrM E(p-p)(TM-TM )-$2Ornil . 21 where Thi is the variance of the market return rM To develop the process, EWI must invest in a research and development project. The cost c of this project will be known shortly after the project is begun (when a technical uncertainty will be resolved). The current estimate is that the cost will be either c-$20mil or c- S16mil and each of these is equally likely. (This uncertainty is uncorrelated with the final price and is also uncorrelated with the market.) Assume that the risk-free rate is 9% and the expected return on the market is M 33%. (a) What is the expected rate of return of this project? (b) What is the beta of this project? Hint: In this case, note thatErM-FM)-EE-rM) (c) Is this an acceptable project based on a CAPM criterion? In particular, what is the excess rate of return (+ or -) above the return predicted by the CAPM