Marwa Manufacturing estimates that its WACC is 11% if equity comes from retained earnings. However, if the company issues new stock to raise new equity, it estimates that its WACC will raise to 12.5%. 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:

Project

Size

IRR

A

$ 750,000

14.0%

B

1,150,000

13.5%

C

1,250,000

12.2%

D

1,250,000

12.0%

E

600,000

11.0%

F

750,000

10.3%

G

800,000

10.2%

a- 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, and what is the firm’s optimal capital budget?

b- Now assume that C and D are mutually exclusive. Project C has NPV of $300,000 while project D has NPV of $350,000. Which set of projects should be accepted?

c- Ignore part b, and assume that each of the projects is independent but the management decides to incorporate project risk differentials. Management judges Project B,C, and D to have average risk; project A to have high risk, and project E,F and G to have low risk. The company adds 2.5% to the WACC of those projects that are significantly more risk than average, and it subtract 2.5% from the WACC of those projects that are substantially less risky than average. Which set of projects should be accepted, and what is the firm new optimal capital budget.

Project

Size

IRR

A

$ 750,000

14.0%

B

1,150,000

13.5%

C

1,250,000

12.2%

D

1,250,000

12.0%

E

600,000

11.0%

F

750,000

10.3%

G

800,000

10.2%

a- 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, and what is the firm’s optimal capital budget?

b- Now assume that C and D are mutually exclusive. Project C has NPV of $300,000 while project D has NPV of $350,000. Which set of projects should be accepted?

c- Ignore part b, and assume that each of the projects is independent but the management decides to incorporate project risk differentials. Management judges Project B,C, and D to have average risk; project A to have high risk, and project E,F and G to have low risk. The company adds 2.5% to the WACC of those projects that are significantly more risk than average, and it subtract 2.5% from the WACC of those projects that are substantially less risky than average. Which set of projects should be accepted, and what is the firm new optimal capital budget.

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