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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 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
  1. 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?
  2. 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?
  3. 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.

Summary Introduction

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.

Explanation

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:

ProjectSizeInternal rate
of return
(IRR)
A$750,00014.0%
B$1,250,00013.5%
C$1,250,00013.2%
D$1,250,00013.0%
E$750,00012.7%
F$750,00012.3%
G$750,00012.2%

The formula to compute the optimal capital budget is as follows:

Optimal capital budget=Sum of all the accepted projects

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.

Summary Introduction

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

c.

Summary Introduction

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

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