Malia Construction estimates that its WACC is 10% if equity comes from retained

Question

Malia Construction estimates that its WACC is 10% if equity comes from retained earnings. However, if the company issue new stock to raise new equity, it estimates that its WACC will rise to 10.8%. The company believes that it will exhaust its retained earnings at $2.5 million of capital due to the number of highly profitable projects available to the firm and its limited earnings. The company is considering the following seven investment projects: Project Size IRR A $650,000 14.0% B $1,050,000 13.5% C $1,000,000 11.2% D $1,200,000 11.0% E $500,000 10.7% F $650,000 10.3% G $700,000 10.2% Assume that each of these projects is independent and that each is just as risky as the firm’s existing assets. Which set of projects should be accepted, and what is the firm’s optimal capital budget?

Explanation / Answer

Project   Size IRR A                      650,000 14.0% B                   1,050,000 13.5% C                   1,000,000 11.2% D                   1,200,000 11.0% E                      500,000 10.7% F                      650,000 10.3% G                      700,000 10.2% Total                     5,750,000 Th firm can accept all the projects. For projects E, F ,G the firm can use the reatined earning of $1.85 million as the WACC 10%   of retained earning is less than the returns provided by the projects E,F,G. Remaining $0.65 million and fund from new equity with WACC of 10.8% can be used for funding the projects A to D as the returns from those projects are 11% and above. So the optimal capital Budget is $5,750,000

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