Question

Over-the-Top Canopies (OTC) is evaluating two independent investments. Project S costs $150,000 and has an IRR equal to 12 percent, and Project L costs $140,000 and has an IRR equal to 10 percent. OTC’s capital structure consists of 20 percent debt and 80 percent common equity, and its component costs of capital are rdT5 4%, rs5 10%, and re5 12.5%. If OTC expects to generate $230,000 in retained earnings this year, which project(s) should be purchased? SHOW ALL WORK

Answer 1

Retained earnings breakpoint=Retained earnings/Fraction of equity=230000/80%=287500.00

If funds required is less than 287500.00, no external equity will be needed

Cost of capital using retained earnings=Sum(weight of source*cost of source)=20%*4%+80%*10%=8.8000%

Cost of capital using external equity=Sum(weight of source*cost of source)=20%*4%+80%*12.5%=10.8000%

We should select Project S as it has return more than the cost of capital using both the sources. Now we see that once we have selected Project S, if we also want to select Project L (as they are independent, we can theoretically choose both) we would need to raise additional equity as total funds required become 290000 which is more than 287500, computed above. And if we raise external equity, the cost of capital becomes 10.8% and hence reject Project L

Hence, Select only Project S