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) SInce the IRR of all the projects is greater than the WACC = 12% all can be selected as long as they can be funded by the retained earnings. The sum total budget for all the projects = 6750000 which is more than the retained earnings of 3250000 If a new stock is issued WACC becomes 12.5% Now if we select all the projects except project G, all the projects will have IRR less than WACC.

The capital budget will be 6000000. with 3250000 from retained earnings and new equity of 2750000 The WACC will then be 12.22%.

b) The IRR of project C is more than the the IRR of project D but the NPV is greater for project D. Since NPV is a better judge as it takes into account the time value of money, we should prefer project D over project C. So now taking project C out of eqution, all other projects apart from project G can be selected

the capital budget will be 4750000 with 3250000 from retained earnings and new equity of 150000. the Wacc will be 12.15%

c) After the given conditions the WACC of project A becomes less than the WACC of the firm and this it should not be selected. Apart from that all other projects can be selected

the optimal capital bdget will be 6000000 with 3250000 as retained earnings and 2750000 as new equity and the WACC will be 12.23%

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