Ziege Systems is considering the following independent projects for the coming y
ID: 2664799 • Letter: Z
Question
Ziege Systems is considering the following independent projects for the coming year:
Project Retained investment Rate of Return Risk
A $4 million 14.0% High
B 5 million 11.5 High
C 3 million 9.5 Low
D 2 million 9.0 Average
E 6 million 12.5 High
F 5 million 12.5 Average
G 6 million 7.0 Low
H 3 million 11.5 Low
Ziege's WACC is 10%, but it adjusts for risk by adding 2% to the WACC for high-risk projects and subtracting 2% for low-risk projects.
a) Which projects should Ziege accept if it faces no capital constrains ?
b) If Ziege can only invest a total of $13 million, which projects should it accept and what would be the dollar size of its capital budget ?
c) Suppose Ziege can raise additional funds beyond the $13 million, but each new increment ( or partial increment) of $5 million of new capital will cause the WACC to increase by 1%. Assuming that Ziege uses the same method of risk adjustment, which projects should it now accept and what would be the dollar size of its capital budget ?
Explanation / Answer
ANSWER TO A
A simple practical approach to incorparate risk differences in projects is to adjust the firm WACC and use the adjusted WACC to evaluate investment . its Adjusted WACC =WACC +_ R (2%)
Low risk projects include modernisation and replacement projects
Medium risk projects include investment of expansion of current buisiness
High risk projects include diversification into new business
Project Return Risk Adjusted WACC Accept reject
a 14 High 12 a
b 11.5 high 12 b
c 9.5 low 8 c
d 9 avg 10 d
e 12.5 High 12 e
f 12.5 average 10 f
g 7 Low 8 g
h 11.5 low 8 h
So A C E F H projects can be accepted on capital crieterion
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