Optimal Capital Budget

Hampton Manufacturing estimates that its WACC is 12% if equity comes from retained earnings. However if the company issues new stick to raise new equity it estimates that its WACC will rise to 12.5%. The company believes that it will
exhaust its retained earnings at $3250000 of capital due to the number of highly profitable following seven investment projects:

Projects Size IRR

A $750000 14.0%

B $1250000 13.5

C $1250000 13.2

D $1250000 13.0

E $750000 12.7

F $750000 12.3

G $750000 12.2

a. Assume that each of these projects is independent and that each is just as risky as the firm%u2019s existing assets. Which set of projects should be
accepted and what is the firm%u2019s optimal capital budget?

b. Now assume that Projects C and D are mutually exclusive. Project D has an NPV of $400000 whereas Project C has an NPV of $350000. Which set of
projects should be accepted and what is the firm%u2019s optimal capital budget?

c. Ignore Part b and assume that each of the projects is independent but that management decides to incorporate project risk differentials. Management
judges Projects B C D and E to have average risk; Project A to have high risk; and Projects F and G to have low risk. The company adds 2% to the
WACC of those projects that are significantly more risky than average and it subtracts 2% 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%u2019s optimal capital budget?