When you say in-house, do you mean the company you currently work for yourself, or just the recruiter works directly for the company hiring but you are not part of that company currently?
If not your company, I would be wary.. they are potentially soliciting a lot of free work. Would they be able to benefit from the project work you're doing directly? I would ask for an agreement to be compensated like contract work if they use any of your project without hiring you.
Your own company? I'd still take some thought and conversation into the mix. Usually they have some sort of range in mind so I could be wrong but on the surface it seems like they are trying to get the best "value" hire that will low-bid themselves but still have quality work. THey need to pay fair market value.
I once did a project for an internal promotion and wasn't chosen, then they wanted to use my work in their programs AND asked me to cover the person they did hire when she went on maternity leave. It was still good experience and I think it was valid of them to ask for a test (part of the role was instructional design and facilitation) but extremely disrespectful in the way they handled it. Maybe ask upfront if you will be able to get in-depth feedback on your project regardless if you are chosen, ask if job description and pay grade are already decided on the role or if it's still being structured into the pay architecture, and explore what other potential opportunities could stem from this project (maybe you're not right for THIS role but the project shows some skill that might make you a valuable add to other projects that could expand your reach and responsibility?)
Good luck!
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