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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

OPTIMAL CAPITAL BUDGET Marble Construction estimates that its WACC is 10% if equity comes from retained earnings. However, if the company issues 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 $2,500,000 of capital due to the number of highly profitable projects available to the firm and its limited earnings. The company is considering the following 7 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?

Summary Introduction

To determine: The set of projects that is accepted and the optimal capital budget of the firm.

Introduction:

The planning process that is utilized to find the long-term investments of the firm such as a new plant, machinery, replacement of machinery, and research and development worth’s the funding from the firm’s capital is termed as capital budgeting.

Explanation

Given information:

M Company has a WACC of 10 percent when the equity is derived from retained earnings and WACC is 10.8 percent when company issues new stock to increase new equity. The retained earnings are $2,500,000 and there are seven projects that the company considers which are as follows:

ProjectSizeInternal Rate of Return (IRR)
A$650,00014%
B$1,050,00013.50%
C$1,000,00011.20%
D$1,200,00011.00%
E$500,00010.70%
F$650,00010.30%
G$700,00010.20%

Determine the set of projects that is accepted:

M Company will accept Project A, Project B, Project C, and Project D. It is because the IRR of each project has a WACC greater than 10.8%...

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