Fundamentals of Financial Manageme...
Fundamentals of Financial Manageme...
OPTIMAL CAPITAL BUDGET Hampton Manufacturing estimates that its VVACC is 125%. The company is considering the following 7 investment projects:
| Project | Size | IRR |
| A | $750,000 | 14.0% |
| B | 1,250,000 | 13.5 |
| C | 1,250,000 | 13.2 |
| D | 1,250,000 | 13.0 |
| E | 750,000 | 12.7 |
| F | 750,000 | 12.3 |
| G | 750,000 | 12.2 |
- a. 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?
- b. Now assume that Projects C and D are mutually exclusive. Project D has an NPV of $400,000, whereas Project C has an NPV of $350,000. Which set of projects should be accepted, and what is the firm’s optimal capital budget?
- c. Ignore part b and assume that each of the projects is independent but that management decides to incorporate project risk differentials. Management judges Projects B, C, D, and E to have average risk. Project A to have high risk, and Projects F and G to have low risk. The company adds 2% to the WACC of those projects that are significantly more risky than average, and it subtracts 2% from the WACC of those projects that are substantially less risky than average. Which set of projects should be accepted, and what Is the firm’s optimal capital budget?
a.
To determine: The set of projects that is accepted and the optimal capital budget of the firm.
Introduction:
Optimal capital budget is an estimation made to determine a value-maximizing level of new investment or project. It indicates the pattern of returns for the entire projects of the firm.
Given information:
H Company has a weighted average cost of capital (WACC) of 12.5 percent. The company has 7 investment projects which are as follows:
| Project | Size | Internal rate of return (IRR) |
| A | $750,000 | 14.0% |
| B | $1,250,000 | 13.5% |
| C | $1,250,000 | 13.2% |
| D | $1,250,000 | 13.0% |
| E | $750,000 | 12.7% |
| F | $750,000 | 12.3% |
| G | $750,000 | 12.2% |
The formula to compute the optimal capital budget is as follows:
Determine the set of projects that must be accepted by the company:
Note: Every project is independent and every project is risky as the existing assets of the company.
The projects whose IRR is greater than WACC must be accepted by the company. In this case, the WACC of the company is 12.5 percent. Therefore, the Project A, Project B, Project C, Project D, and Project E will be accepted by the company
b.
To determine: The set of projects that is accepted and the optimal capital budget of the firm.
c.
To determine: The set of projects that is accepted and the optimal capital budget of the firm.
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