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The board of a major bank is discussing their investment appraisal methodology as they have a new project under consideration. They have agreed that using the CAPM approach is sensible as they feel it likely that most of their shareholders have a well-diversified shareholding in the stock market as a whole.
There has been some dispute about which risks constitutes specific risks in the bank and which risks are more systematic in nature partly driven by the nature of the bank’s operations. Equally, no one seems quite sure what the required return derived from the CAPM formula actually represents.
The finance director has produced the following data relating to the bank itself, the financial market and the new project it is considering:
Data
Required return on existing debt, 6.0%
Cost of existing debt to the bank, 4.8%
Return on short-dated gov secur’s, 5.2%
Return in the stock market (index), 12.8%
Equity beta of the bank (levered), 1.35
Beta of the new project, 1.52
Asset beta of the bank (unlevered), 1.15
In CAPM, what would be the value to use for the risk free rate of return (rRF), from the data above?
Group of answer choices
5.2%
4.16%
6.0%
4.8%