The answer to the question is highlighted in red. Explanations are highlighted in green.
10. Options Infinity Limited (OIL) is considering the following independent, non-divisible capital budgeting projects:
Initial investment Internal rate
Project outlay (cost) of
return, IRR
R $250,000 18.5%
W 200,000 15.0
Z 180,000 14.0
OIL can raise new funds to invest in capital budgeting projects based on the following schedule:
Amount raised Cost,
r = WACC
$ 1 - $150,000 12.0%
$150,001 - $400,000 14.5
$400,001 and above 16.0
According to this information, which project(s) should OIL accept?
a. Project R only
b. Projects R and W
c. Projects R, W, and Z
d. Projects W and Z
e. None of the above is correct.
If OIL purchases Project R only, it will need $250,000 in
funds. Because $250,000 in funds has a cost of capital (WACC) equal to 12
percent, Project R is acceptable. If OIL purchases Projects R and W, it will
need $450,000 in funds. If OIL needs $450,000, the WACC will be 16 percent,
which means Project W is not acceptable—that is IRRW = 15% < 16%.
As a result, only Project R should be purchased.