A company has a WACC1125 for funding up to 4 million when re

A company has a WACC1=12.5% for funding up to $4 million when retained earnings are used. They also have a WACC2=13.7% for funding above $4 million when new equity is raised. If they have the following independent investment opportunities, which projects should the company include in their budget? What is the company’s optimal capital budget?

Project A: Cost of $2 million; IRR 20%.
Project B: Cost of $3 million; IRR 14%
Project C: Cost of $4 million; IRR 13%

Solution

IRR stands for the internal rate of return. It actually tells how much a project is going to yield over its lifespan. So, we can say that if IRR of a project is greater than its cost of capital, it will result in positive cash flows and profits.

So, we should select Project A & Project B as both the projects yield higher returns. However, as Project C has lesser IRR than the WACC for funding above $4 million, it will start eating up the profits for the former projects.