Question

Firm A has 11 equally risky capital budgeting projects, each costing $29.608 million and each having an expected rate of return of 8.25%. Firm A’s retained earnings breakpoint is $296.08 million. The firm’s WACC using retained earnings is 8.0% but increases to 8.5% if new equity must be issued. The company invests in projects where the expected return exceeds the cost of capital. How much capital should Firm A raise and invest?

Answer 1

Answer:

How much capital should Firm A raise and invest?

The answer is:

$296.08 million should be raised and invested in projects.

Explanation:

WACC = 8% when A's retained earnings breakeven point = $296.08 million

Expected rate of return = 8.25%

WACC is less than expected rate of return.

Therefore, WACC is less than expected rate of return, which is beneficial, since cost of capital is less than expected rate of return.

therefore, $296.08 million should be raised.

If the firm A raises, more than $296.08 million, WACC would be increasing to 8.5%, this is greater than the expected rate of return i.e. 8.25%.

Hence raising amount more than $296.08 million will not be beneficial.

Hence it is clear that amount which should be raised and invested =$296.08 million.

Investment required in one project=$29.608 million.

Number of projects which can be started =$296.08/$29.608  =10 projects

All are equally risky therefore it does not matter which project should be left.

Hence, $296.08 million should be raised and invested in projects.