Question

Avery Manufacturing is considering the following capital projects. The internal rate of return (IRR) has been calculated for each project. Project Cost (Millions of dollars) IRR 11.6% $40 $40 $80 11.2% 10.8% The optimal capital budget (OCB) is the budget size that maximizes the firm's wealth given the opportunities for investment and the cost of capital. Avery's managers have plotted the marginal cost of capital (MCC) schedule to reflect how the cost of capital increases as new capital is raised. Assume that the proposed projects are independent and equally risky and that their risks are equal to Avery's average existing assets.

Answer 1

In order to determine the optimal capital budget, given the available investment opportunities to the firm, one needs to look at the graph provided. The blue curve (that slopes downward in steps) graphs the available investment opportunities' IRR and level of investment. The orange curve (that slopes upward in steps) is the marginal cost of capital graph that denotes the capital being targeted and the corresponding cost associated with the same. The optimal capital budget is provided by the point of intersection of these two graphs.

As is observable, the optimal capital budget in this case is $ 80 million and the corresponding WACC at that level of capital is 11%