Capital budgeting
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1. Carry & Co. is in the process of analyzing its investment decision-making procedures. The two projects evaluated by the firm during the past months were Project 263 and 264. The basis variables surrounding each project analysis, using the IRR decision technique, and the resulting decision actions are summarized in the following table.
Basic Variables Project 263 Project 264
Cost $64,000 $58,000
Life 15 years 15 years
IRR 8% 15%
Least-cost financing
Source Debt Equity
Cost (after-tax) 7% 16%
Decision
Action Accept Reject
Reason 8% IRR > 7% cost 15% IRR < 16% cost
a. Evaluate the firm's decision-making procedures, and explain why the acceptance of Project 263 and rejection of Project 264 may not be in the owner's best interest.
b. If the firm maintains a capital structure containing 40% debt and 60% equity, find its weighted average cost using the data in the table.
c. If the firm had used the weighted average cost calculated in part b, what actions would have been indicated relative to projects 263 and 264.
d. Compare and contrast the firm's actions with your findings in part c. Which decision method seems more appropriate? Explain why.
2. Dennis Corporation has compiled the information shown in the following table.
Source of Capital Book Value Market Value After-Tax Cost
Long-term debt $4,000,000 $3,840,000 6.0%
Preferred stock 40,000 60,000 13.0
Common stock equity 1,060,000 3,000,000 17.0
Totals $5,100,000 $6,900,000
a. Calculate the weighted average cost of capital using book value weights.
b. Calculate the weighted average cost of capital using market value weights.
c. Compare the answers obtained in parts a and b. Explain the differences.
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The solution explains two problems relating to capital budgeting
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