Capital Corporation, which has a target capital structure of 40 percent debt and

Question

Capital Corporation, which has a target capital structure of 40 percent debt and 60 percent common equity, is evaluating an expansion project with an 8.5 percent IRR. The project costs $6 million, and any portion of it can be purchased. The firm expects to retain $4.8 million of earnings this year. It can raise up to $2 million in new debt with rd = 6%; all debt above $2 million will have rd = 8%; rs = 11%; and re = 14% for any amount of new common stock that is issued. If the firm's marginal tax rate is 35 percent, what is its optimal capital budget?

Explanation / Answer

Given The project costs $6 million and target capital structure of 40 percent debt and 60 percent common equity

Hence, Debt portion of capital = $6 million x 40% = $2.4 millions

Equity portion of capital = $6 million x 60% = $3.6 millions

Optimal Capital Budget is given below :

$2 million in new debt with rd = 6% ------> $2 millions.

$0.4 million of debt with rd = 8% ---------> $0.4 millions

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Debt portion (40%) -----------------------> $2.4 millions

Equity Raised is Retained earnings with Re = 14% = $3.6 millions.

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Total Optimal capital budget = $ 6 millions

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