Question

A firm is reviewing its next year’s budget with the following projects.

Project	A	B	C	D
IRR	9.0%	9.5%	10.5%	10.0%
Capital Required	$0.5 million	$0.7 million	$1.5 million	$0.8 million

A capital structure of 60% debt and 40% equity needs to be kept.  Besides $0.6 million retained earnings, firm can also borrow up to $1.2 million at an after-tax cost of 5%.  For any new debt, the rate is 7% after tax.  The cost of existing equity is 9% and the cost of new equity is 12%.  How much is the optimal budget?          

Answer 1

Project	A	B	C	D
1.IRR	9.00%	9.50%	10.50%	10.00%
2.Capital Required (in $ mlns.)	0.5	0.7	1.5	0.8
3.Debt (60%*2)--- In $ mlns.)	0.3	0.42	0.9	0.48
4.Equity(40%*2)----(in $ mlns.)	0.2	0.28	0.6	0.32
5.After-tax cost of debt(kd)	7%	7%	7%	7%
6.Cost of existing equity(ke)	9%	9%	9%	9%
7.WACC=(Wt.d*kd)+(wt.e*ke)	7.80%	7.80%	7.80%	7.80%
(60%*kd)+(40%*ke)
8. IRR-WACC (1-7)	1.20%	1.70%	2.70%	2.20%

From the above table, it can be seen that the difference between IRR & WACC is maximum for project C , meaning it will be most profitable & add more value to the company.

Hence the optimal budget will be that for C --Debt-- $ 0.9 mln. & Equity(retained Earnings-- $ 0.6 mln.