Project Risk Analysis

The managers of United Medtronics are evaluating the following four projects for the coming budget period. The firm's corporate cost of capital is 14 percent.

Project	Cost	IRR
A	$15,000	17%
B	$15,000	16%
C	$12,000	15%
D	$20,000	13%

a. Assuming that all four projects have average risk, what is the firm's optimal capital budget?

b. Now, suppose Medtronic's managers want to consider differential risk in the capital budgeting process. Project A has average risk, B has below-average risk, C has above-average risk, and D has average risk. What is the firm's optimal capital budget when differential risk is considered?

(Hint: The firm's managers lower the IRR of high-risk projects by 3 percentage points and raise the IRR of low-risk projects by the same amount.)