, project 1 and project 2.Each project would require an immediate cash outlay of Sh.10,000,000.Investor Ltd. expects to have available enough resources to undertake only one of the projects.

The directors of Investor Ltd. believe that returns from existing activities and from the new projects will depend on which of the three economic environments prevails during the coming year.They estimate returns for the coming year (that is, cash flows to be received at the end of the year plus project value at that time), and the probabilities of the three possible economic environments, as follows:

Economic environment

A

B

C

Probability of economic environment

0.3

0.4

0.3

Sh.

Sh.

Sh.

Returns form project 1

12,500,000

12,500,000

9,500,000

Returns form project 2

10,000,000

11,750,000

13,000,000

Aggregate returns from existing portfolio of projects

90,000,000

120,000,000

130,000,000

The company has a current market value of Sh.100,000,000.The directors of Investor Ltd. believe that the risks and returns per shilling of market value of their existing activities are similar to those of the stock market as a whole, including their dependence on whichever economic environment prevails.The current rate of interest on short-term government securities is 10% per annum.

Required:

Using the capital asset pricing model (CAPM), advise the directors of Investor Ltd. on which of the two proposed projects should be accepted.(20 marks)