Optimal capital budget Hampton Manufacturing estimates that its WACC is 12 % 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 12.5 %. The company believes that it will exhaust its retained earnings at $3, 250,000 of capital due to the number of highly profitable projects available to the firm and its limited earnings. The company is considering the following 7 investment projects:
Project Sides 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 now 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 for those that are substantially less risky than average. Which set of projects should be accepted, and what is the firm's optimal capital budget?
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The firm would take the projects in order of its IRR. First, project A would be selected than project B and so ...
Tutorial guides you through the reasoning needed to identify the optimal budget.