QUESTION ONE

Alpha Corporation’s present capital structure, which is also its target capital structure, calls
for 50% debt and 50% percent common equity. The firm has only one potential project, an
expansion program with a 10.2% IRR and a cost of $20 million but which is completely
divisible, that is, Alpha can invest any amount up to $20 million. The firm expects to retain
$2 million of earnings next year and to generate $2 million in depreciation cash flow. It can
raise up to $5 million in new debt at a before tax cost of 8%, and all debt after the first $5
million debt will have a cost of 10%. The cost of retained earnings is 12% and the firm can
sell any amount of new common stock desired at a constant cost of new equity of 15%. The
tax rate applicable to the company is 40%.

Required

Calculate the firm’s optimal capital budget.

QUESTION 2

Alpha Corporation’s present capital structure, which is also its target capital structure, calls
for 40% debt and 60% percent common equity. The firm has two potential projects whose
cash flows are shown in tables below.

Project A
Year 0 1 2 3 4 5

Net Cash flows -20,000 6,000 8,000 5,000 5,000 4,500

Project B
Year 0 1 2 3 4 5

Net Cash flows -15,000 3,750 4,500 3,750 3,750 3,750

The firm expects to retain $2,000 of earnings next year and to generate $1,000 in depreciation
cash flow. It can raise up to $6,000 in new debt at a before tax cost of 8%, and all debt after
the first $6,000 debt will have a cost of 10%. The cost of retained earnings is 10% and the
firm can sell any amount of new common stock desired at a constant cost of new equity of
15%. The tax rate applicable to the company is 40%.
Required:

Estimate the firm’s optimal capital budget and comment on its significance.