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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

PROJECT SELECTION Midwest Water Works estimates that its WACC is 10.5%. The company is considering the following capital budgeting projects:

Project Size Rate of Return
A $1 million. 12.0%
     
B 2 million 11.5
     
c 2 million 11.2
D 2 million 11.0
     
E 1 million 10.7
     
F 1 million 10.3
     
G 1 million 10.2

Assume that each of these projects is just as risky as the firm’s existing assets and that the firm may accept all the projects or only some of them Which set of projects should be accepted? Explain.

Summary Introduction

To identify: The set of projects that should be accepted with reasons.

Introduction:

Weighted Average Cost of Capital (WACC):

It is the weighted average cost of all the source through which the firm finances its capital. It is  the rate that a company will pay to all for raising finance. It can be termed as the firm’s cost of capital. The company raises money through various sources such as common stock and preference share debt. The WACC is calculated by taking the relative weight of each item of the capital structure.

The formula to calculate WACC is,

WACC=Wdrd(1t)+WPrp+Wcrs

Where,

  • Wd is the weight of the debt.
  • WP is the weight of the preferred stock.
  • Wc is the weight of the equity.
  • rd is cost of the debt.
  • rP is cost of the preferred stock.
  • rc is the cost of the equity.

Internal Rate of Return (IRR):

It is defined as the discount rate that determines the return that an investor expects from a project. IRR occurs at the breakeven point that is when the net present value (NPV) is zero. It helps in decision making while accepting the project. When IRR is more than the cost of capital/WACC, the project is recommended to be accepted.

Explanation

The projects which have the higher return than WACC should be accepted. The project A, B, C, D and E has higher return than WACC. So these projects should be accepted.

The WACC of the company is 10.5 %. Thus the project which has a higher return than 10...

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