Question

Marble Construction estimates that its WACC is 8% 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 8.8%. The company believes that it will exhaust its retained earnings at $2,700,000 of capital due to the number of highly profitable projects available to the firm and its limited earnings. The company is considering the following seven investment projects:

Project	Size			IRR
A		$    650,000		13.5	%
B		1,040,000		13.3
C		1,050,000		8.3
D		1,250,000		9.1
E		520,000		9.0
F		650,000		8.1
G		750,000		8.0

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?

Project A	-Select-acceptdon't acceptItem 1
Project B	-Select-acceptdon't acceptItem 2
Project C	-Select-acceptdon't acceptItem 3
Project D	-Select-acceptdon't acceptItem 4
Project E	-Select-acceptdon't acceptItem 5
Project F	-Select-acceptdon't acceptItem 6
Project G	-Select-acceptdon't acceptItem 7

What is the firm's optimal capital budget? Round your answer to the nearest dollar.

$  

Answer 1

The projects that should be accepted shall be those in which the rate of return exceeds the WACC.

So, the projects that should be accepted shall be Projects A, B, D and E since the rate of return in these projects exceeds the WACC of 8.8%.

The remaining projects i.e. Projects C, F and G shall not be accepted.

The firms capital budget represents the size of investment in the projects that we have accepted.

So, the firm's optimal capital budget will be computed as follows:

= $ 650,000 + $ 1,040,000 + $ 1,250,000 + $ 520,000

= $ 3,460,000

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