Optimal Capital Budget

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Choosing the Optimal Capital Budget  Finance theory says to accept all positive NPV projects.  Two problems can occur when there is not enough internally generated cash to fund all positive NPV projects:

Increasing Marginal Cost of Capital

Externally raised capital can have large flotation costs, which increase the cost of capital. Investors often perceive large capital budgets as being risky, which drives up the cost of capital. (More...)

An increasing marginal cost of capital. Capital rationing Copyright © 1999 by The Dryden Press All rights reserved.

Copyright © 1999 by The Dryden Press

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Capital Rationing If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital. Capital rationing occurs when a company chooses not to fund all positive NPV projects. The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year. (More...)

Copyright © 1999 by The Dryden Press All rights reserved. Copyright © 1999 by The Dryden Press All rights reserved.

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Reason: Companies want to avoid the direct costs (i.e., flotation costs) and the indirect costs of issuing new capital. Solution: Increase the cost of capital by enough to reflect all of these costs, and then accept all projects that still have a positive NPV with the higher cost of capital. (More...)

Copyright © 1999 by The Dryden Press All rights reserved.

Reason: Companies don’t have enough managerial, marketing, or engineering staff to implement all positive NPV projects. Solution: Use linear programming to maximize NPV subject to not exceeding the constraints on staffing. (More...)

Copyright © 1999 by The Dryden Press All rights reserved.

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Blum Industries has 5 potential projects:

We’ve seen how to evaluate projects. We need cost of capital for evaluation.

But corporate cost of capital depends on size of capital budget. Must combine WACC and capital budget analysis.

Project Cost CF Life (N) IRR A $400,000 $119,326 5 15% B 200,000 56,863 5 13 B* 200,000 35,397 10 12 C 100,000 27,057 5 11 D 300,000 79,139 5 10 Projects B & B* are mutually exclusive, the others are independent. Neither B nor B* will be repeated. Copyright © 1999 by The Dryden Press All rights reserved.

Copyright © 1999 by The Dryden Press

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Additional Information
Interest rate on new debt Tax rate Debt ratio Current stock price, P0 Last dividend, D0 Expected growth rate, g Flotation cost on CS, F Expected addition to RE (NI = $500,000, Payout = 60%.) 8.0% 40.0% 60.0% $20.00 $2.00 6.0% 19.0% $200,000

Calculate WACC, then plot IOS and MCC schedules.
Step 1: Estimate the cost of equity
D0(1 + g) + g = $2(1.06) + 6% = 16.6%. P0 $20 D1 $2(1.06) + 6% ke = +g= P0(1 - F) $20(1 - 0.19) ks = = $2.12 + 6% = 19.1%. $16.2
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For differential project risk, add or subtract 2% to WACC.
Copyright © 1999 by The Dryden Press All rights reserved.

Copyright © 1999 by The Dryden Press

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Step 2: Estimate the WACCs
WACC1 = w dkd(1 - T) + w ceks = (0.6)(8%)(0.6) + 0.4(16.6%) = 9.5%.

Step 3: Estimate the RE break point BPRE =

Retained earnings Equity fraction
$200,000 = $500,000. 0.4

=
WACC2 = w dkd(1 - T) + w ceke = (0.6)(8%)(0.6) + 0.4(19.1%) = 10.5%.

Each dollar up to $500,000 has $0.40 of RE at cost of 16.6%, then WACC rises. Only 1 compensating cost increase, so only 1 break point. Copyright © 1999 by The Dryden Press All rights reserved.

Copyright © 1999 by The Dryden Press

All rights reserved.

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11 - 13 % 16 15 14 13 12 11 10 9 WACC1 = 9.5% D

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FIGURE 1
A B B* C WACC2 = 10.5%
MCC IOS

The IOS schedule plots projects in descending order of IRR. Two potential IOS schedules--one with A, B, C, and D and another with...
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