Question

Marble Construction estimates that its WACC is 10 percent ifequity comes from retained earnings. However, if the company issuesnew stock to raise new equity, it estimates that its WACC will riseto 10.8 percent. The company believes that it will exhaust itsretained earnings at $2,500,000 of capital due to the number ofhighly profitable projects available to the firm and its limitedearnings. The company is considering the following seven investmentprojects:
Project Size IRR

A $650,000 14.0%

B 1,050,000 13.5

C 1,000,000 11.2

D 1,200,000 11.0

E 500,000 10.7

F 650,000 10.3

G 700,000 10.2

Assume that each of these projects is independent and that eachis just as risky as the firm’s existing assets. Which set ofprojects should be accepted, and what is the firm’s optimalcapital budget?

Answer 1

Answer:

Projects E,F and G should NOT be considered.

Optimal Capital  is $5,750,000

Explanation:

The accept-or-reject rule, using the IRR method, is to acceptthe project if its Internal Rate of Return (IRR) is higher than theWeighted Average Cost of Capital(k) [r>k]. The project shall berejected if its internal rate of return is e lower than theWeighted Average Cost of Capital cost of (r<k)

                                 Accept if        r>k

                                 Reject if         r<k

                                   Mayaccept if r = k

If the Weighted Average Cost of Capitl (WACC) is less than IRRrate, then the project has positive NPV; if it is equal to IRR, theproject has a Zero NPV, and if it is greater than the IRR, theproject has negative NPV.

The projects should be accepted as the rate of return on theproject is higher than the WACC(10.8%) which means that theprojects will be profitable as the returns are higher than the costof the project (capital).  Considering this projects E,F and G should NOT be considered.

And considering the sizes the Optimal Capital  is $5,750,000 (the addition of sizes of all projects)