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# Capital Budgeting Weighted Average Cost of Capital

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For questions 26 through 34 use the following cash flows (if otherwise unspecified use a WACC of 6%):

Cash Flows
Years Project A Project B
0 \$ (500,000.00) \$ (500,000.00)
1 \$ 80,000.00 \$ 280,000.00
2 \$ 130,000.00 \$ 230,000.00
3 \$ 180,000.00 \$ 180,000.00
4 \$ 270,000.00 \$ 130,000.00
5 \$ 300,000.00 \$ 80,000.00

26. If the weighted average cost of capital for the firm is 4% and the projects are mutually exclusive, which project would you choose based upon the NPV rule?
27. If the weighted average cost of capital for the firm is 4% and the projects are independent, which project would you choose based upon the NPV rule?
28. If the weighted average cost of capital for the firm is 18% and the projects are mutually exclusive, which project would you choose based upon the NPV rule?
29. What is the Internal Rate of Return for Project A?
30. What is the Payback for Project B?
31. What is the Discounted Payback for Project A?
32. What is the Profitability Index for Project A?
33. What is the Discounted Profitability Index for Project B?
34. What is the Cross-Over Rate Between the two Projects?

#### Solution Summary

1. Net Present Value
2. Internal Rate of Return
3. Payback
4. Discounted Payback
5. Profitability Index
6. Cross-Over Rate Between the two Projects

\$2.19

## Weighted Average Cost of Capital and Optimal Capital Budget

QUESTION 1

A. Karen Wallace currently has an investment portfolio that contains 10 stocks that have a total value equal to \$160,000. The portfolio has a beta (b) equal to 1.0. Karen wants to invest an additional \$40,000 in a stock with b = 2.0. After Karen adds the new stock to her portfolio, what will be the portfolio's beta?

B. Given the following information, compute the expected return, standard deviation and coefficient of variation for Company B.:

Probability Return
0.2 2.0%
0.3 12.0%
0.5 5.0%

QUESTION 2

Your company is considering two mutually exclusive projects, X1 and X2; also considered are 2 projects, Y and Z, independant of the X projects and each other. The project costs and cash flows are shown below:

0 -\$2,000 -\$2,000 -\$15,000 -\$25,000
1 200 2,000 5,000 8,500
2 600 200 5,000 8,500
3 800 100 5,000 8,500
4 1,400 75 5,000 8,500

Projects X1 and X2 are equally risky, and the firm's required rate of return is 12 percent. Which projects should be accepted and which should be rejected? Base your decision on any method, but justify the use of the method you have chosen.

QUESTION 3
ONE
* A company has a capital structure of 45% debt, 5% preferred stock and 50% common equity.

(a) The company can obtain unlimited debt at an interest rate of 10%. The marginal tax rate is 35%. Find the after-tax cost of debt.

(b) Preferred stock carries a dividend of \$14 and currently sells for \$120.00. Flotation cost on preferred stock is €10 per share. What is the cost of preferred stock?

(c) Their current stock price is \$25. The next dividend is expected to be \$2.56 and growth is constant at 8%. If new common stock is issued, it will have a flotation cost of 10%. Find the cost of retained earnings and the cost of issuing new common shares.

(d) If the net income is expected to be \$1,600,000, and the company's policy is to pay 50% of net income for dividends, what is the break point caused by using all of retained earnings?

(e) Find the WACC using retained earnings and the WACC when new equity is issued.

TWO
* A company has a WACC1=12.5% for funding up to \$4 million when retained earnings are used. They also have a WACC2=13.7% for funding above \$4 million when new equity is raised. If they have the following independent investment opportunities, which projects should the company include in their budget? What is the company's optimal capital budget?

Project A: Cost of \$2 million; IRR 20%.
Project B: Cost of \$3 million; IRR 14%
Project C: Cost of \$4 million; IRR 13%

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