Marble Construction estimates that its WACC is 10 percent ifequity comes from re
ID: 2770660 • Letter: M
Question
Marble Construction estimates that its WACC is 10 percent ifequity comes from retained earnings. However, if the company issuesnew stock to raise new equity, it estimates that its WACC will riseto 10.8 percent. The company believes that it will exhaust itsretained earnings at $2,500,000 of capital due to the number ofhighly profitable projects available to the firm and its limitedearnings. The company is considering the following seven investmentprojects:
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 eachis just as risky as the firm’s existing assets. Which set ofprojects should be accepted, and what is the firm’s optimalcapital budget?
Explanation / Answer
The accept-or-reject rule, using the IRR method, is to acceptthe project if its Internal Rate of Return (IRR) is higher than theWeighted Average Cost of Capital(k) [r>k]. The project shall berejected if its internal rate of return is e lower than theWeighted Average Cost of Capital cost of (r<k)
Accept if r>k
Reject if r<k
Mayaccept if r = k
Project
Size
Rate of Return
A
$650,000
14.00%
B
$1,050,000
13.5%
C
$1,000,000
11.20%
D
$1,200,000
11.00%
The above projects should be accepted as the rate of return on theproject is higher than the WACC(10.8%) which means that theprojects will be profitable as the returns are higher than the costof the project (capital).
Project
Size
IRR
A
$650,000
14.00%
B
$1,050,000
13.50%
C
$1,000,000
11.20%
D
$1,200,000
11.00%
E
$500,000
10.70%
F
$650,000
10.30%
G
$700,000
10.20%
Optimal Capital
$5,750,000
Hope it may help you
Project
Size
Rate of Return
A
$650,000
14.00%
B
$1,050,000
13.5%
C
$1,000,000
11.20%
D
$1,200,000
11.00%