Question

OPTIMAL CAPITAL BUDGET Hampton Manufacturing estimates that its WACC is 12.5%. The company is considering the following seven investment projects: Project Size IRR A $750,000 14.0% B 1,250,000 13.5 C 1,250,000 13.2 D 1,250,000 13.0 E 750,000 12.7 F 750,000 12.3 G 750,000 12.2 Assume that each of these projects is independent and that each is just as risky as the firm's existing assets. Which set of projects should be accepted? Project A -Select-AcceptDon't acceptItem 1 Project B -Select-AcceptDon't acceptItem 2 {C} Project C -Select-AcceptDon't acceptItem 3 Project D -Select-AcceptDon't acceptItem 4 {C} Project E -Select-AcceptDon't acceptItem 5 Project F -Select-AcceptDon't acceptItem 6 {C} Project G -Select-AcceptDon't acceptItem 7 What is the firm's optimal capital budget? Write out your answer completely. For example, 13 million should be entered as 13,000,000. $ Now assume that Projects C and D are mutually exclusive. Project D has an NPV of $ 400,000, whereas Project C has an NPV of $350,000. Which set of projects should be accepted? Project A -Select-AcceptDon't acceptItem 9 {C} Project B -Select-AcceptDon't acceptItem 10 Project C -Select-AcceptDon't acceptItem 11 {C} Project D -Select-AcceptDon't acceptItem 12 Project E -Select-AcceptDon't acceptItem 13 {C} Project F -Select-AcceptDon't acceptItem 14 Project G -Select-AcceptDon't acceptItem 15 {C} What is the firm's optimal capital budget in this case? Write out your answer completely. For example, 13 million should be entered as 13,000,000. $ Ignore Part b and now assume that each of the projects is independent but that management decides to incorporate project risk differentials. Management judges Projects B, C, D, and E to have average risk, Project A to have high risk, and Projects F and G to have low risk. The company adds 2% to the WACC of those projects that are significantly more risky than average, and it subtracts 2% from the WACC of those projects that are substantially less risky than average. Which set of projects should be accepted? Project A -Select-AcceptDon't acceptItem 17 {C} Project B -Select-AcceptDon't acceptItem 18 Project C -Select-AcceptDon't acceptItem 19 {C} Project D -Select-AcceptDon't acceptItem 20 Project E -Select-AcceptDon't acceptItem 21 {C} Project F -Select-AcceptDon't acceptItem 22 Project G -Select-AcceptDon't acceptItem 23 {C} What is the firm's optimal capital budget in this case? Write out your answer completely. For example, 13 million should be entered as 13,000,000. $

Answer 1

Ques 1
As the projects are independent and have the same level of risk as the overall firm, the company should select all of the projects which have an IRR greater than the firm’s WACC of 12.5%. Thus, the firm should select projects A, B, C, D and E and its optimal capital budget is the sum of the costs of these projects ($5,250,000).

Ques 2
If projects C and D are mutually exclusive, then the firm can only select one of them rather than both. Based on the NPV criteria, the firm should select Project D as it provided a higher NPV (and also has a higher IRR). As a result, the firm’s capital budget is now $4,000,000 and includes projects A, B, D and E.

Ques 3
Based on this risk-adjustment criteria:
•Required return (WACC) for Low-risk projects = 12.5% - 2.0% = 10.5%
•Required return for Average-risk projects = 12.5%
•Required return for High-risk projects = 12.5% + 2.0% = 14.5%

Low-risk projects
•Projects F and G will both be accepted because their IRRs (12.3% and 12.2%) are greater than the required return of 10.5%

Average-risk projects
•Projects B, C, D and E will still be accepted because their IRRs are greater than the firm’s average required return (WACC) of 12.5%

High-risk projects
•Project A will be rejected because its IRR of 14.0% is less than the required return on high-risk projects of 14.5%

Thus, the selected projects are projects B, C, D, E, F and G and the firm’s optimal capital budget is $6,000,000.