Part A

The cost of debt for firm XYZ is 6%. Its tax rate is 40%. The cost of retained earnings is 12% and the cost of external common equity is 14%. Retained earnings are $5000. The target capital structure calls for 45% debt and 55% equity. Compute the following:

A. Retained earnings break point

B. WACC below the RE break point

C. WACC above the RE break point

Part B

The firm referred to in part A has 3 projects available: One with a cost of $4000 and an IRR of 18%; one with a cost of $3000 and an IRR of 20%; and one with a cost of $6000 and an IRR of 6%. Do the following:

Compute the optimal capital budget. In other words, how much capital must the firm raise in order to invest in all projects whose IRR exceeds the WACC?

What projects should be accepted?