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:

1. Determine the WACC for Bam Corporation.
2. 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