Question

Bam Corporation is considering the following independent projects for the coming year. Their target capital structure is 60 percent debt and 40 percent equity. The after-tax cost of debt is 6 percent and the cost of equity is 15 percent.

Expected

Required Rate of Risk

Project Investment Return Level

A $13 million 17% High

B 16 million 9 Low

C 25 million 14 Average

D 10 million 8 Low

E 18 million 16 High

Bam adjusts its WACC for risk by adding 2% to the WACC for high-risk projects and subtracting 1.0% for low-risk projects.

Required:

- Determine the WACC for Bam Corporation.
- Determine which projects Bam Corporation should accept and what would be the dollar size of its capital budget.

Answer #1

WACC = After tax cost of Debt*Weight of Debt + Cost of Equity*Weight of Equity | |||||

=6%*60% + 15%*40% = 9.6% | |||||

Project | Rate of return | Risk Level | WACC | Required Return | Decision |

A | 17% | High | 9.60% | 10.60% | Accept |

B | 9% | Low | 9.60% | 8.600% | Accept |

C | 14% | Average | 9.60% | 9.60% | Accept |

D | 8% | Low | 9.60% | 8.600% | Reject |

E | 16% | High | 9.60% | 10.60% | Accept |

Projects whose rate of return is higher than required return should be accepted | |||||

i.e. A, B, C and E | |||||

Capital Budget = 13 million+16 million+25 million + 18 million = $72 million |

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