Question

1. The firm referred to in problem #1 has 3 projects available: One with a cost of $4000 and an IRR of 18%; one with a cost of $3000 and an IRR of 20%; and one with a cost of $6000 and an IRR of 6%. Do the following:
   
   Compute the optimal capital budget. In other words, how much capital must the firm raise in order to invest in all projects whose IRR exceeds the WACC?
   What projects should be accepted?

Answer 1

Calculation of WACC

WACC , Weighted Average Cost of Capital is the average rate of return expected in total by all of its investors whether Equity shareholder, Preference shareholder and debenture holders who has invested money in the company.

WACC = Return on Equity * Equity share capital / Total capital employed

+

Return on debentures * Debentures capital / Total Capital employed

Here, Total Capital employed will comprise of Equity and debenture capital. If , the company has preference capital also then it will also be included .

WACC in terms of projects is calculated as below :

WACC = Return from Project 1 expected + Return form Project 2 expected + Return form Project 3    expected / Total Cost

= Cost of Project 1 * IRR of P1 + Cost of Project 2 * IRR of P2 + Cost of Project 3 * IRR of P3 / Total cost

= $ 4,000 * .18 + $ 3,000 * .20 + $ 6,000 * .06 / $ 13,000

= $ 1,680 / $ 13,000

= 0.1292

or

12.92 % is the wieghted average cost of capital expected on overall basis by the company from all the 3 projects if the company wishes to invest in all 3 projects.

Note : Total Cost of all 3 projects = $ 4,000 + $ 3,000 + $ 6,000

= $ 13,000

Optimal capital budget

Now, WACC = 12.92 %

IRR of Project 1 = 18%

IRR of Project 2 = 20%

IRR of Project 3 = 6%

So, IRR of Project 1 & 2 are exceeding WACC , so, Optical Capital Budget wiil be $ 7,000 ($ 4,000 + $ 3,000)

Cost of Project 1 & 2 is $ 7,000

So $ 7,000 capital must be raised by firm in order to invest in these 2 projects (Project 1 of $ 4,000 % Project 2 of $ 3,000) whose IRR exceeds the WACC.

What projects should be accepted?

Project 1 & 2 should be accepted with the Cost of $ 4,000 & $ 3,000 respectively.

we are opting only for these 2 projects because their IRR is more than the WACC of the company .

Basically , the cost of Project 3 , $ 6,000 and that too such a low IRR of 6% is calculating the WACC at such a low rate of 12.92%.

this is because when we compute the WACC of Project 1 & 2 we get WACC = 18.85 %.

So, the firm must accept Project 1 & 2 and arrange for $ 7,000 in total .