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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

ADJUSTING COST OF CAPITAL FOR RISK Ziege Systems is considering the following independent projects for the coming year:

images

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.

  1. a. Which projects should Ziege accept if it faces no capital constraints?
  2. 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?
  3. 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?

a.

Summary Introduction

To identify: The project Z Systems should accept if its faces no capital constraints.

Introduction:

Risk Adjusted WACC

The firms should consider the risk associated with a particular project. The risk is high or low in the project should be checked and the WACC should be adjusted. Thus risk adjusted WACC is used to assess projects.

Explanation

The following projects should be accepted.

Project

Required

Investment

(in million

dollars)

Rate of

Return

(%)

RiskAdjusted WACC
H311.5Low 10%2%=8%
C39.5Low 10%2%=8%
F 512.5Average10%
A 414.0High 10%+2%=12%
E612.5High 10%+2%=12%

Table (1)

Working note:

Computation of adjusted WACC of individual projects

Project

Required

Investment

(in million

dollars)

Rate of

Return

(%)

RiskAdjusted WACC
A414

b.

Summary Introduction

To identify: The projects that should be accepted by Z system and the dollar size of its capital project.

c.

Summary Introduction

To determine: The project should be accepted by the company now and the dollar size of its capital budget.

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