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a)Assume that the projects are of average risk. What is Dilbert's optimal capital budget? Which projects should be undertaken? (b)What is the corporate cost of capital the firm should use for budgeting purposes? (c)Now suppose it was discovered that project A has been ruled out because of an environmental ruling. . How would this change your answers to questions (a) and (b)? Be specific.

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Dilbert Industries is developing its optimal capital budget for the coming year. They have identified the five potential projects shown below. Projects B and B* are mutually exclusive, while the remainder of the projects are independent.
Project Cost Cash flow Life (n) IRR NPV
(each year)
A $400K $119,326 5 15%
B $200K 56,863 5 13%
B* $200K 35,397 10 12%
C $100K 27,057 5
D $300K 79,139 5

The following information was developed for purposes of determining Dilbert's weighted average cost of capital (WACC):

Interest rate on new debt 8.0%
Tax rate 40.0%
Debt ratio (Debt/Assets) 60%
Current stock price, P0 $20.00
Last Dividend, D0 $2.00
Expected growth rate, g 6.0%
Flotation cost on common, F 19.0%
Expected addition to retained earnings $200,000

(a)Assume that the projects are of average risk. What is Dilbert's optimal capital budget? Which projects should be undertaken? (b)What is the corporate cost of capital the firm should use for budgeting purposes? (c)Now suppose it was discovered that project A has been ruled out because of an environmental ruling. . How would this change your answers to questions (a) and (b)? Be specific.

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Solution Preview

(a)Assume that the projects are of average risk. What is Dilbert's optimal capital budget? Which projects should be undertaken?

For projects C and D, we compute the IRR by:
C: input PV = -100,000, payment = 27057, n = 5
By a financial calculator or EXCEL (=RATE(5,27057,-100000)):
Compute internal return rate = 11%

D: input PV = -300,000, payment = 79,139, n = 5
By a financial calculator or EXCEL (=RATE(5,79139,-300000)):
Compute ...

Solution Summary

Detailed notes show reasoning process and computations. No references.

$2.19