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QUESTION
Hampton Manufacturing estimates that its WACC is 12.5%. The company is considering the following seven investment projects: $$ \begin{matrix} \text{Project} & \text{Size} & \text{IRR}\\ \text{A} & \text{\$ 750.000} & \text{14.0\\%}\\ \text{B} & \text{1.250.000} & \text{13.5}\\ \text{C} & \text{1.250.000} & \text{13.2}\\ \text{D} & \text{1.250.000} & \text{13.0}\\ \text{E} & \text{750.000} & \text{12.7}\\ \text{F} & \text{750.000} & \text{12.3}\\ \text{G} & \text{750.000} & \text{12.2}\\ \end{matrix} $$ 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 Projects C and D are mutually exclusive. Project D has an NPV of $400,000, whereas Project C has an NPV of$350,000. Which set of projects should be accepted, and what is the firm’s 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’s optimal capital budget?
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QUESTION
Elliott Athletics is trying to determine its optimal capital structure, which now consists of only debt and common equity. The firm does not currently use preferred stock in its capital structure, and it does not plan to do so in the future. Its treasury staff has consulted with investment bankers. On the basis of those discussions, the staff has created the following table showing the firm’s debt cost at different debt levels: $$ \begin{matrix} \text{Debt-to-Capital Ratio }{\left(\mathbf{w}_{\mathbf{d}}\right) } & \text{Equity-to Capital Ratio }{\left(\mathbf{w}_{\mathbf{c}}\right)} & \text{Debt-to-Equity Ratio (D/E)} & \text{Bond Rating} & \text{Before-Tax Cost of Debt }{\left(\mathbf{r}_{\mathrm{d}}\right)}\\ \text{0.0} & \text{1.0} & \text{0.00} & \text{A} & \text{7.0\\%}\\ \text{0.2} & \text{0.8} & \text{0.25} & \text{BBB} & \text{8.0}\\ \text{0.4} & \text{0.6} & \text{0.67} & \text{BB} & \text{10.0}\\ \text{0.6} & \text{0.4} & \text{1.50} & \text{C} & \text{12.0}\\ \text{0.8} & \text{0.2} & \text{4.00} & \text{D} & \text{15.0}\\ \end{matrix} $$ Elliott uses the CAPM to estimate its cost of common equity, rs, and estimates that the risk-free rate is 5%, the market risk premium is 6%, and its tax rate is 40%. Elliott estimates that if it had no debt, its “unlevered” beta, $b_{U}$, would be 1.2. a. What is the firm’s optimal capital structure, and what would be its WACC at the optimal capital structure? b. If Elliott’s managers anticipate that the company’s business risk will increase in the future, what effect would this likely have on the firm’s target capital structure? c. If Congress were to dramatically increase the corporate tax rate, what effect would this likely have on Elliott’s target capital structure? d. Plot a graph of the after-tax cost of debt, the cost of equity, and the WACC versus (1) the debt/capital ratio and (2) the debt/equity ratio.
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