Question

Required Investment Rate of Return Project Risk A $4 million 13.00% High 5 million 10.50 High 3 million 8.50 Low 8.00 Average 2 million 6 million 11.50 High 5 million 11.50 Average 6 million 6.00 Low 3 million 11.00 LOW Ziege's WACC is 9.00%, but it adjusts for risk by adding 2% to the WACC for high-risk projects and subtracting 2% for low-risk projects. a. Which projects should Ziege accept if it faces no capital constraints? Project A Reject Project B Accept Reject 9 Project C Project D Project E Accept Reject . Drniert F

Answer 1

WACC Excess return (RR-WACC) 2.00% Project A В C Required investment ($ mn) 4 5 3 2 6 5 Rate of return (RR) 13.00% 10.50% 8.50% 8.00% 11.50% 11.50% 6.00% 11.00% 1.50% Risk High High Low Average High Average Low Low 11.00% 11.00% 7.00% 9.00% 11.00% 9.00% 7.00% 7.00% Decision Accept Reject Accept Reject Accept Accept Reject Accept E 0.50% 2.50% 3 4.00%

a). WACC for a project will be as:

High risk: 9% + 2% = 11%

Low risk: 9%-2% = 7%

Average: 9%

Comparing this with the rate of return for each project, all those projects which have rate of return > WACC are accepted and the rest are rejected. With no capital constraint, projects A, C, E, F and H are accepted.

b). Since there is a capital constraint of $13 million now, we look at excess returns (RR - WACC) generated by each project and accept the projects having the greatest excess returns. As can be seen from the table above, the acceptable projects which greatest excess return are projects A, F and H. The dollar size of the capital budget is 4 + 5 + 3 = $12.00 million.

c). The remaining two acceptable projects are projects C and E. If they are accepted, theie WACC will increase by 1%. Then, WACC for project C becomes 7%+1% = 8% and for project E becomes 11%+1% =12%. Project E has a return of 12% so if its WACC is 12%, it becomes unacceptable. Thus, only project C can be accepted as its rate of return is still greater than its new WACC of 8%. So, the acceptable projects now, are projects A, C, F and H. The dollar size of the capital budget now becomes 12 + 3 = $15.00 million.