When conducting a capital budget analysis, all incremental cash flows relating to the proposal

are included in the analysis. DMac Barny Ltd has an asset base of $400 million and a capital

structure of 50% Debt and 50% Equity. The company plans to maintain this structure with any

new investments. The company has a target weighted average cost of capital of 12%.

You have been tasked with reviewing a major capital budget analysis prepared by DMac

Barny's CFO Dianne McGrath which uses 12% as the required rate of return. You are aware that

the project requires additional capital of $200 million; which under the target capital structure

will require an additional $100 million of debt to be raised. You are aware that at present

DMac Barny Ltd can raise debt funds at a cost of 5% which will require meeting additional

interest costs of $5 million per annum. In reviewing the analysis prepared by Ms McGrath you

can see that these significant cash flows associated with these additional (incremental)

interest payments have been included.

a. Provide a thorough and critical analysis explaining why Ms McGrath should, or should not,

include the payments on interest for the borrowings for the new project in her capital budget

(approx. 150 words) (5 marks).

b. You are advised by the debt finance manager that they believe that the company will only

be able to raise $50 of the required $100 million debt needed for the project and that equity

raising will need to lift from $100 to $150 million in order to compensate and raise the full $200

million needed. You are advised that this change will not impact the individual cost of debt

and the cost of equity. Given the changes to capital raising outlined above advise Ms McGrath on whether her capital budget analysis of the project using a WACC of 12% remains relevant including why WACC is a critically important facet of the Capital Budgeting process. (include any calculations) (approx. 300 words)