OPTIMAL CAPITAL BUDGET Marble Construction estimates that its WACC is 10% if equ

Question

OPTIMAL CAPITAL BUDGET

Marble Construction estimates that its WACC is 10% if equity comes from retained earnings. However, if the company issues new stock to raise new equity, it estimates that its WACC will rise to 10.8%. The company believes that it will exhaust its retained earnings at $2,500,000 of capital due to the number of highly profitable projects available to the firm and its limited earnings. The company is considering the following seven investment projects:

Assume that each of these projects is independent and that each is just as risky as the firm's existing assets. Which set of projects should be accepted?

What is the firm's optimal capital budget? Write out your answer completely. For example, 13 million should be entered as 13,000,000.
$

Project Size IRR A $650,000 14.0% B 1,050,000 13.5 C 1,000,000 11.2 D 1,200,000 11.0 E 500,000 10.7 F 650,000 10.3 G 700,000 10.2

Explanation / Answer

Select all projects.

With retained earnings of 2,500,000 and WACC = 10%, finance projects A, E, F and G for a total capital of $2,500,000 as IRR of these projects is greater than 10%.

With new equity at WACC = 10.8%, finance projects B, C and D for a total capital of $3,250,000 as IRR of these projects is greater than 10.8%.

Optimal capital budget = $2,500,000 + $3,250,000 = $5,750,000

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