Question

The CFO of a manufacturing firm is determining the capital budget. Currently the market value of the firm' equity and debt are $4 billion and $12 billion, respectively. The company’s debt trades with a yield to maturity of 8%, and its equity has an expected return of 14%. The firm’s marginal tax rate is 30%.

The projects that are under consideration have different risk and returns. The company estimates that low-risk projects have a cost of capital of 8% and high-risk projects have a cost of capital of 18%.

Project                  Expected Return                   Risk

A 16% High

B 12% Average

C 10% Low

D 9% Low

E 6% Low

(a) Compute the company’s weighted average cost of capital (WACC).

(b) The Finance Manager suggests to invest only in projects which expected rate of returns are higher than the firm’s WACC. Do you agree with the Finance Manager? Justify your answers with reference to the use of WACC.

(c) To maximize shareholder wealth, which of the projects should the CFO select to invest in? Evaluate each project separately and provide the justification.

Answer 1

B)