Optimal Capital Budget
Hampton Manufacturing estimates that its WACC is 12% if equity comes from retained earnings. However if the company issues new stick 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 $3250000 of capital due to the number of highly profitable following seven investment projects:
Projects Size IRR
A $750000 14.0%
B $1250000 13.5
C $1250000 13.2
D $1250000 13.0
E $750000 12.7
F $750000 12.3
G $750000 12.2
a. Assume that each of these projects is independent and that each is just as risky as the firm%u2019s existing assets. Which set of projects should be
accepted and what is the firm%u2019s optimal capital budget?
b. Now assume that Projects C and D are mutually exclusive. Project D has an NPV of $400000 whereas Project C has an NPV of $350000. Which set of
projects should be accepted and what is the firm%u2019s optimal capital budget?
c. Ignore Part b and 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 of those projects that are substantially less
risky than average. Which set of projects should be accepted and what is the firm%u2019s optimal capital budget?