3. Your company is looking at the folliowing investments. None of the investment

Question

3. Your company is looking at the folliowing investments. None of the investments ane mutually exclusive: Investment $6 million $10 million Investment A nvestment 8 Investment C $ 2 million Investment D Investment E Investment F Investment G Rinsk Assessment Return [IRR) Average risk Higher than average 14% Average risk Below Average risk 8% Average rish tigher than average 25% Below Average risk is 12% 18% $ 30 million $75 million $ 1 million $ 8 million 9% The company has a targeted capital structure of 35% debt and 65% equity. The tax rate is 30%. The stock has a Beta of 1.8; the risk free rate is estimated to be 3.5% with a market risk premium of 7%. Existing bonds are priced in the market to yield 7%, The company uses the WACC to create a hurdle rate for average risk average risk they wil add a 3% premium to the WACC, f subtract 2% from the WACC to create a hurdle rate for these projects. projects. For higher than For lower than average risk they will Based on the above criteria, which projects are Skely to be approved? List the projects in the order at which they clear their respective hurdle rates i.e. clear their hurdle rates by the highest %. Which of the approved projects will have the highest Valuation impact on the company? Does anything worry you about the lkely-to-be approved projects vs. the ones not approved?

Explanation / Answer

after tax cost of debt

YTM*(1-tax rate)

7*(1-.35)

4.55

cost of equity

risk free rate+(risk premium)*beta

3.5+(7)*1.8

16.1

WACC

weight

cost

weight*cost

debt

0.35

4.55

1.5925

equity

0.65

16.1

10.465

WACC

sum of weight*cost

12.0575

Higher than average risk

hurdle rate = WACC+3%

12.0575+3%

15.0575

lower than average risk

hurdle rate = WACC-2%

12.0575-2

10.0575

Investment

RISK ASSESSMENT

Hurdle rate

IRR

Acceptance or rejection

A

AVERAGE

12.0575

12%

reject

B

Higher than average risk

15.0575

14%

reject

C

AVERAGE

12.0575

18%

accept

D

lower than average risk

10.0575

8%

reject

E

AVERAGE

12.0575

9%

reject

F

Higher than average risk

15.0575

25%

accept

G

lower than average risk

10.0575

11%

accept

C

Higher than average risk

15.0575

25%

accept

F

AVERAGE

10.0575

18%

accept

G

lower than average risk

10.0575

11%

accept

Project c will have the highest impact on the company

project lower than average is the big concern for the non accpted project

after tax cost of debt

YTM*(1-tax rate)

7*(1-.35)

4.55

cost of equity

risk free rate+(risk premium)*beta

3.5+(7)*1.8

16.1

WACC

weight

cost

weight*cost

debt

0.35

4.55

1.5925

equity

0.65

16.1

10.465

WACC

sum of weight*cost

12.0575

Higher than average risk

hurdle rate = WACC+3%

12.0575+3%

15.0575

lower than average risk

hurdle rate = WACC-2%

12.0575-2

10.0575

Investment

RISK ASSESSMENT

Hurdle rate

IRR

Acceptance or rejection

A

AVERAGE

12.0575

12%

reject

B

Higher than average risk

15.0575

14%

reject

C

AVERAGE

12.0575

18%

accept

D

lower than average risk

10.0575

8%

reject

E

AVERAGE

12.0575

9%

reject

F

Higher than average risk

15.0575

25%

accept

G

lower than average risk

10.0575

11%

accept

C

Higher than average risk

15.0575

25%

accept

F

AVERAGE

10.0575

18%

accept

G

lower than average risk

10.0575

11%

accept

Project c will have the highest impact on the company

project lower than average is the big concern for the non accpted project

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