Question

A financial analyst needs to evaluate two independent investments and decide which projects should be purchased. Project A costs $150,000 and has an IRR of 12 percent, and Project B costs $140,000 and has an IRR of 10 percent. The capital structure consists of 20 percent debt and 80 percent common equity, and its component costs of capital are rdt 5 4%, rs 5 10%, and re 5 12.5%. If the company expects to generate $230,000 in retained earnings this year, which project(s) should be purchased?

Any important formulas or steps appreciated

Answer 1

Project	Cost	IRR
A	150,000	12%
B	140,000	10%
	Capital	Debt	Equity	WACC
Weight		0.20	0.80
Cost (with retained earnings)	230,000	4.00%	10.00%	8.80%
Cost (using external equity)	After 230,000	4.00%	12.50%	10.80%

As can be seen from the data above, if we start with the project which has the greater IRR of the two given projects (which is project A) and the lowest WACC of 8.80% (using retained earnings) then project A should be accepted as its IRR > MCC (marginal cost of capital). However, when we come to project B, it will cross the WACC (using retained earnings) since after investing in A, retained earnings left = 230,000 - 150,000 = 80,000. Which means that 140,000-80,000 = 60,000 of capital will have to be raised from outside which will make the MCC for project B as 10.80%. Here the MCC > IRR, so project B should be rejected.

Result: Accept project A.