The mangers of United Medtronicss are evaluating the following four projects for
ID: 2715010 • Letter: T
Question
The mangers of United Medtronicss are evaluating the following four projects for the coming budget period. The firms corporate cost of capital is 14 percent.
Project
Cost
IRR
A
$15,000
17%
B
$15,000
16%
C
$12,000
15%
D
$20,000
13%
a. What is the firm's optimal capital budget?
b. Now, suppose Medtronic's managers want to consider differential risk in the capital budgeting process. Project A has average risk, B has below-average risk, C has above-average risk, and D has average risk. What is the firm's optimal capital budget when differential risk is considered? (Hint: The firm's managers lower the IRR of high-risk projects by 3 percentage points and raise the IRR of low-risk projects by the same amount.)
Project
Cost
IRR
A
$15,000
17%
B
$15,000
16%
C
$12,000
15%
D
$20,000
13%
a. What is the firm's optimal capital budget?
b. Now, suppose Medtronic's managers want to consider differential risk in the capital budgeting process. Project A has average risk, B has below-average risk, C has above-average risk, and D has average risk. What is the firm's optimal capital budget when differential risk is considered? (Hint: The firm's managers lower the IRR of high-risk projects by 3 percentage points and raise the IRR of low-risk projects by the same amount.)
Explanation / Answer
Part A)
In the given case, we can accept Project A, B and C as their IRR is higher than the firm's cost of capital. Project D is not acceptable as its IRR is less than the cost of capital.
If the projects are independent with no capital rationing in place, we can accept all the 3 projects and the optimal capital budget would be $42,000 (15,000 + 15,000 + 12,000).
If the projects are mutually exclusive, we can accept only Project A as it offers the highest IRR. In such a case, optimal capital budget would be $15,000.
________
Part B)
The revised IRR after adjustment for risk level would be:
If the projects are independent with no capital rationing in place, we can accept projects A and B (because of IRR's greater than cost of capital) and the optimal capital budget would be $30,000 (15,000 + 15,000).
If the projects are mutually exclusive, we can accept only Project B as it offers the highest IRR of 19%. In such a case, optimal capital budget would be $15,000.
Project Cost Risk Level Adjustment IRR A $15,000 Average - 17% B $15,000 Below Average 3% 19% (16%+3%) C $12,000 Above Average -3% 12% (15% - 3%) D $20,000 Average - 13%Related Questions
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