Michigan Industries has three projects under consideration. Project L is a lower
ID: 2764886 • Letter: M
Question
Michigan Industries has three projects under consideration. Project L is a lower-than-average-risk project, project A is an average-risk project, and project H is a higher-than-average-risk project. You have gathered the following information to determine if one or more of these projects has an acceptable rate of return for the firm. • Sources of financing 50% debt and 50% equity • Rd = 8.00% before taxes • Tax Rate = 30% • Average beta for Michigan Industries = 1.0 • Rm = 13.00% • Rf = 4.00% • Adjusted WACC = 9.30% • Beta for project L = 0.80, for project A = 1.00, and for project H = 1.20 • IRRL = 9.00%, IRRA = 10.00%, and IRRH = 11.00% Calculate the required rate of return for each project and determine which, if any, projects are acceptable to the firm.
Explanation / Answer
Answer
Particulars
Risk free rate
Beta
Market return - Risk free rate
Beta * (Market return - Risk free rate)
Cost of equity (%)
A
B
C
D
(13-4)
B*C
A+D
Project L
4
0.8
9
7.2
11.2
Project A
4
1
9
9
13
Project H
4
1.2
9
10.8
14.8
Particulars
Cost of debt after tax
8*(1-0.3)
Project L
5.6
Project A
5.6
Project H
5.6
Particulars
Cost of debt after tax
Proportion of debt
Weighted cost of debt
Cost of equity
Proportion of Equity
Weighted cost of equity
Weighted cost of capital or required rate of return (WACC %)
IRR (%)
Project should be accepted or not
Reason
A
B
C
D
E
F
A*B
D*E
C+F
Project L
5.6
0.5
2.8
11.2
0.5
5.6
8.4
9
Accepted
IRR>WACC
Project A
5.6
0.5
2.8
13
0.5
6.5
9.3
10
Accepted
IRR>WACC
Project H
5.6
0.5
2.8
14.8
0.5
7.4
10.2
11
Accepted
IRR>WACC
Particulars
Risk free rate
Beta
Market return - Risk free rate
Beta * (Market return - Risk free rate)
Cost of equity (%)
A
B
C
D
(13-4)
B*C
A+D
Project L
4
0.8
9
7.2
11.2
Project A
4
1
9
9
13
Project H
4
1.2
9
10.8
14.8