Midwest Water Works estimates that its retained earnings break point, Bpre, is $
ID: 2642902 • Letter: M
Question
Midwest Water Works estimates that its retained earnings break point, Bpre, is $5 million, and its WACC is 10 percent 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 10.5 percent. The company is considering the following seven investment projects: Project Size IRR A $1 million 12.00% B 2 million 11.5 C 2 million 11.2 D 2 million 11 E 1 million 10.7 F 1 million 10.3 G 1 million 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? Refer to problem above. Now assume that Projects C and D are mutually exclusive. Project D has a NPV of $400,000, whereas Project C has a NPV of $350,000. Which set of projects should be accepted, and what is the firm's optimal capital budget? Midwest Water Works estimates that its retained earnings break point, Bpre, is $5 million, and its WACC is 10 percent 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 10.5 percent. The company is considering the following seven investment projects: Project Size IRR A $1 million 12.00% B 2 million 11.5 C 2 million 11.2 D 2 million 11 E 1 million 10.7 F 1 million 10.3 G 1 million 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? Refer to problem above. Now assume that Projects C and D are mutually exclusive. Project D has a NPV of $400,000, whereas Project C has a NPV of $350,000. Which set of projects should be accepted, and what is the firm's optimal capital budget?Explanation / Answer
Answer:
In the books of Midwest Water Works:
1.According to the given IRR :
Projects A, B, C, D , E should be accepted asthey incurr more IRR in comparison to the Weighted Average Cost of Capital (WACC) while Projects F and G should be rejected as they incurr less IRR as compared to the WACC.
2.New Weighted Average Cost of Capital (WACC) after accepting new project as given would be 10.5 %
3.For mutually exclusive projects, the decision rule is to choose the project with the greatest NPV.
Since, NPV of Project D > NPV of Project C , Project D should be accepted based upon its NPV.
Here, Optimal Capital Budget as given will be 10.5%