# Optimal Capital Budget

11 – 1 11 – 2 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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All rights reserved. 11 – 9 11 – 10 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 All rights reserved. For differential project risk, add or subtract 2% to WACC.