Michigan Industries has three projects under consideration. Project L

Michigan Industries has three projects under consideration. Project L is a lower-than-average-risk project, project A is an average-risk project, and project H is a higher-than-average-risk project.

You have gathered the following information to determine if one or more of these projects has an acceptable rate of return for the firm.

• Sources of financing 50% debt and 50% equity
• Rd = 8.00% before taxes
• Tax Rate = 30%
• Average beta for Michigan Industries = 1.0
• Rm = 13.00%
• Rf = 4.00%
• Adjusted WACC = 9.30%
• Beta for project L = 0.80, for project A = 1.00, and for project H = 1.20
• IRRL = 9.00%, IRRA = 10.00%, and IRRH = 11.00%

Calculate the required rate of return for each project and determine which, if any, projects are acceptable to the firm.
What will be an ideal response?

ANSWER

Answer: Adjusted WACC for each project:
For project L, Re = Rf + β × (Rm – Rf) = 4.00% + 0.80 × (13.00% – 4.00%) = 11.20%
RL = 8.00% × (.50) × (1 -.30) + 11.20% × (.50) = 8.40%
IRRL = 9.00% is greater than RL = 8.40%. Therefore, this is an acceptable project.

For project A, Re = Rf + β × (Rm – Rf) = 4.00% + 1.00 × (13.00% – 4.00%) = 13.00%
RA = 8.00% × (.50) × (1 -.30) + 13.00% × (.50) = 9.30%
IRRA = 10.00% is greater than RA = 9.30%. Therefore, this is an acceptable project.

For project H, Re = Rf + β × (Rm – Rf) = 4.00% + 1.20 × (13.00% – 4.00%) = 14.80%
RH = 8.00% × (.50) × (1 -.30) + 14.80% × (.50) = 10.20%
IRRH = 11.00% is greater than RH = 10.20%. Therefore, this is an acceptable project.