Question

4.  Problem 12.05 (Optimal Capital Budget)

eBook Marble Construction estimates that its WACC is 10% if equity comes from retained earnings. However, if the company issues new stock to raise new equity, it estimates that its WACC will rise to 10.5%. The company believes that it will exhaust its retained earnings at $2,300,000 of capital due to the number of highly profitable projects available to the firm and its limited earnings. The company is considering the following seven investment projects: Project Size IRR A $    690,000 14.4 % B 1,030,000 13.6 C 1,040,000 10.1 D 1,180,000 10.2 E 520,000 10.6 F 690,000 11.0 G 720,000 9.8 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 Project C -Select-acceptdon't acceptItem 3 Project D -Select-acceptdon't acceptItem 4 Project E -Select-acceptdon't acceptItem 5 Project F -Select-acceptdon't acceptItem 6 Project G -Select-acceptdon't acceptItem 7 What is the firm's optimal capital budget? Round your answer to the nearest dollar. $

Answer 1

1) IRR is the effective return which equates the Present Value of cash inflow to capital outlay.

Hence we can consider IRR as the return from the project. We compare it with cost to take decision whether to accept or reject a project.

Our cost of new capital is 10.40% and cost of retained earning is 10% upto 2.30 million.

We straightaway select the project with IRR higher than 10.40% and straightaway reject the project with IRR below 10%.

We select project A, B, E & F (IRR More than 10.40%)

We reject project G (IRR less than 10%)

For projects between 10% and 10.40% IRR, we may select the project with capital upto 2.30 million

We select project C & D as the capital required ( 1.04+1.18 = 2.22 m) is within available capital of 2.30 million

2) Total Capital required is 11,360,000 for the projects accepted. We use the retained earning of 2,300,000 with cost of 10% and raise fresh equity of 9,060,000 which costs 10.40%.