Optimal Capital Budget Hampton Manufacturing estimates that its WACC is 12% if e

Question

Optimal Capital Budget

Hampton Manufacturing estimates that its WACC is 12% if equity comes from retained earnings. However, if the company issues new stick to raise new equity, it estimates that its WACC will rise to 12.5%. The company believes that it will exhaust its retained earnings at $3,250,000 of capital due to the number of highly profitable following seven investment projects:

                                Projects                               Size                                        IRR

                                A                                      $750,000                                     14.0%

                                B                                      $1,250,000                    13.5

                                C                                      $1,250,000                  13.2

                                D                                      $1,250,000                    13.0

                                E                                       $750,000                                     12.7

                                F                                       $750,000                                     12.3

                                G                                      $750,000                                     12.2

a. Assume that each of these projects is independent and that each is just as risky as the firm%u2019s existing assets. Which set of projects should be accepted, and what is the firm%u2019s optimal capital budget?

b. Now assume that Projects C and D are mutually exclusive. Project D has an NPV of $400,000, whereas Project C has an NPV of $350,000. Which set of projects should be accepted, and what is the firm%u2019s optimal capital budget?

c. Ignore Part b and assume that each of the projects is independent but that management decides to incorporate project risk differentials. Management judges Projects B, C, D, and E to have average risk; Project A to have high risk; and Projects F and G to have low risk. The company adds 2% to the WACC of those projects that are significantly more risky than average, and it subtracts 2% from the WACC of those projects that are substantially less risky than average. Which set of projects should be accepted, and what is the firm%u2019s optimal capital budget?

Explanation / Answer

a.         WACC1 = 12%; WACC2 = 12.5%.

Since each project is independent and of average risk, all projects whose IRR > WACC will be accepted. Consequently, Projects A, B, C, D, and E will be accepted and the optimal capital budget is $5,250,000. After accepting projects A, B, and C, all of retained earnings will be used up and additional equity will be raised to fund the remaining projects, whose WACCs all exceed 12.5%.

b.   If Projects C and D are mutually exclusive, the firm will select Project D, because its NPV is greater than Project C%u2019s NPV. So, the optimal capital budget is $4 million, and consists of Projects A, B, D, and E.

c.   The appropriate costs of capital are 10.5% for low-risk projects, 12.5% for average-risk projects, and 14.5% for high-risk projects. Since Project A is high risk, it will be rejected (14% < 14.5%). Projects B, C, D, and E are all average risk and will be accepted since their returns exceed 12.5%. Projects F and G are low risk and will both be accepted since their returns exceed 10.5%. Therefore, the optimal capital budget is $6 million and consists of Projects B, C, D, E, F, and G.

Related Questions

Navigate

• Browse (All)
• Browse O
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.