Question

Ziege Systems is considering the following independent projects for the coming year:

Project	Required Investment	Rate of Return	Risk
A	$4 million	11.25%	High
B	5 million	13.75	High
C	3 million	9.25	Low
D	2 million	9	Average
E	6 million	12.25	High
F	5 million	12.25	Average
G	6 million	7	Low
H	3 million	11	Low

Ziege's WACC is 9.75%, but it adjusts for risk by adding 2% to the WACC for high-risk projects and subtracting 2% for low-risk projects.

1. Which projects should Ziege accept if it faces no capital constraints?

   Project A	-Select-AcceptRejectItem 1
   Project B	-Select-AcceptRejectItem 2
   Project C	-Select-AcceptRejectItem 3
   Project D	-Select-AcceptRejectItem 4
   Project E	-Select-AcceptRejectItem 5
   Project F	-Select-AcceptRejectItem 6
   Project G	-Select-AcceptRejectItem 7
   Project H	-Select-AcceptRejectItem 8

2. If Ziege can only invest a total of $13 million, which projects should it accept?

   Project A	-Select-AcceptRejectItem 9
   Project B	-Select-AcceptRejectItem 10
   Project C	-Select-AcceptRejectItem 11
   Project D	-Select-AcceptRejectItem 12
   Project E	-Select-AcceptRejectItem 13
   Project F	-Select-AcceptRejectItem 14
   Project G	-Select-AcceptRejectItem 15
   Project H	-Select-AcceptRejectItem 16

   If Ziege can only invest a total of $13 million, what would be the dollar size of its capital budget? Enter your answer in millions. For example, an answer of $10,550,000 should be entered as 10.55. Round your answer to two decimal places.

   $    million

3. Suppose Ziege can raise additional funds beyond the $13 million, but each new increment (or partial increment) of $5 million of new capital will cause the WACC to increase by 1%. Assuming that Ziege uses the same method of risk adjustment, which projects should it now accept?

   Project A	-Select-AcceptRejectItem 18
   Project B	-Select-AcceptRejectItem 19
   Project C	-Select-AcceptRejectItem 20
   Project D	-Select-AcceptRejectItem 21
   Project E	-Select-AcceptRejectItem 22
   Project F	-Select-AcceptRejectItem 23
   Project G	-Select-AcceptRejectItem 24
   Project H	-Select-AcceptRejectItem 25

   What would be the dollar size of its capital budget? Enter your answer in millions. For example, an answer of $10,550,000 should be entered as 10.55. Round your answer to two decimal places.

   $    million

Answer 1

a. For high risk projects add 2% to given Wacc i.e. 9.75% + 2% = 11.75%

For low risk projects subtract 2% to given Wacc i.e. 9.75% - 2% = 7.75%

For Average the same Wacc is taken i.e. 9.75%

Wacc is the weighted AVerage cost of capital. This is the weighted average cost that is expected to be incurred when a firm raises capital for a project .

For a project to be accepted, its expected rate of return should be higher that cost of capital.

Project	Required Investment (In Millions)($)	Rate of Return	Risk	Cost of capital	Excess rate
A	4	11.25%	High	11.75%	-0.50%
B	5	13.75%	High	11.75%	2.00%
C	3	9.25%	Low	7.75%	1.50%
D	2	9%	Average	9.75%	-0.75%
E	6	12.25%	High	11.75%	0.50%
F	5	12.25%	Average	9.75%	2.50%
G	6	7%	Low	7.75%	-0.75%
H	3	11%	Low	7.75%	3.25%

Hence as per the above analysis projects "B,C,E,F,H" should be acepted by Zeige if it faces no capital constraints

b. If zeigi accepts all the projects whose rate of return exceeds the WACC, then the total investment / Project cost should be analysed as under :

Project	Required Investment (In Millions)($)	Rate of Return	Risk	Cost of capital	Excess rate	Cumulative Capital (In Millions)($)
H	3	11%	Low	7.75%	3.25%	3
F	5	12.25%	Average	9.75%	2.50%	8
B	5	13.75%	High	11.75%	2.00%	13
C	3	9.25%	Low	7.75%	1.50%	16
E	6	12.25%	High	11.75%	0.50%	22
A	4	11.25%	High	11.75%	-0.50%	0
G	6	7%	Low	7.75%	-0.75%	0
D	2	9%	Average	9.75%	-0.75%	0

From the above analysis , it can be seen that Projects "H, F, B" can only be selected if it has only $13 Million.

c. To solve this problem consider the computation in part b above.

It is now said that zeigi can raise additional funds beyond $13 Million but with the expense of an additional 1% increase iun Wacc for every 5% Million increase in Cost.

After analysisng the chart in point b it can be seen that project E will now be rejected since the excess rate is only 0.5%. If WACC increase by 1% then the rate of return of Project E will be less than the wacc and will then be rejected . Thus the answer for the question of acceptance of project is now to chose projects "H, F, B, C" and the dollar size will be $16 Million i.e. Required Investment of $3 Million ,$5 Million ,$5 million and $3 million of projects H, F, B & C respectively.