2. Use the concepts of marginal cost and marginal revenue to derive an optimal c

Question

2. Use the concepts of marginal cost and marginal revenue to derive an optimal capital budget for Company X, which has identified 7 possible investment projects and determined its cost of capital as shown below. Hint: Rank the projects according to the rate of return, and continue to invest as long as the ROI is greater than the cost of capital. I'm clueless on this one. Would like an answer, not just a talk through.

Table A: Alternative Projects, Required Investments, and Expected Rate of Return

Project Investment Required in Millions of Dollars Expected Rate of Return on Investment

A 150 12%

B 300 15%

C 125 10%

D 75 16%

E 50 20%

F 500 14%

G 250 18%

Table B: Cost of Capital by Amount Raised

Block of Funds

(in Millions) Amount of Funds

in Block Cost of Capital for Block

First Block of Funds $500 10%

Second Block of Funds $400 11%

Third Block of Funds $300 12%

Fourth Block of Funds $200 13%

Fifth Block of Funds $100 14%

Sixth Block of Funds $100 15%

Explanation / Answer

If you listed the project according to the Return of Investment, the order from high to low will be:

E 50 20%

G 250 18%

D 75 16%

B 300 15%

F 500 14%

A 150 12%

C 125 10%

The cost of capital on the other hand will be,

First Block of Funds $500 10%

so, project E, G, and D will be accepted, where ROI still higher than the cost of capital

money spent = 50+250+75 = 375

leftover = 125

Second Block of Funds $400 11%

project B stil have a higher return than 11%, so continue to spent

125 leftover from first block of fund + 175 from second block of fund = 300 (B)

Leftover of second block of fund = 225

Third Block of Funds $300 12%

Project F with 14% return > 12%,

225 leftover from secnd block of fund + 275 from third block of fund = 500 (F)

Fourth Block of Funds $200 13%

Project A with 12% of return is less than cost of capital, so project A and C will not be run under this circumstances.

Project approved will be (according to order) : E, G, D, B, F

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