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ABC Inc. has a debt ratio of 0.45 and it considers this to be its optimal capital structure. ABC has no preferred stock. ABC has analyzed four capital projects for the coming year as follows:

Project Net Investment IRR
1 $3,000,000 13.5%

2 $1,500,000 18.0%

3 $2,000,000 12.6%

4 $1,600,000 16.0%

ABC expects to earn $2.5 million after tax next year and pay out $700,000 in dividends. Dividends are expected to be $1.15 a share during the coming year and are expected to grow at a constant rate of 8 percent a year for the foreseeable future. The current market price of ABC stock is $23 and up to $2 million in new equity can be raised for a flotation cost of 10 percent. If more than $2 million is sold then the flotation cost will be 15 percent. Up to $2 million in debt can be sold at par with a coupon rate of 10 percent. Any debt over $2 million will carry a 12 percent coupon rate and be sold at par. If ABC has a marginal tax rate of 40 percent, in which projects should it invest and what is ABC's optimal capital budget? (Please draw MCC and IOS curves when answering this problem.)

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