Question

Project Cost Expected Rate of Return 1 $2,000 16.00% 3,000 15.00 5,000 13.75 4 2,000 12.50 The company estimates that it can issue debt at a rate of ra 10 % , and its tax rate is 25%. It can issue preferred stock that pays a constant dividend of $6.00 per year at $45.00 per share. Also, its common stock currently sells for $38.00 per shafe; the next expected dividend, D1, is $4.25; and the dividend is expected to grow at a constant rate of 5% per year. The target capital structure consists of 75% common stock, 15 % debt, and 10 % preferred stock. a. What is the cost of each of the capital components? Do not round intermediate calculations. Round your answers to two decimal places. Cost of debt: % Cost of preferred stock: % Cost of retained earnings: b. What is Adamson's WACC? Do not round intermediate calculations. Round your answer to two decimal places. % C. Only projects with expected returns that exceed WACC will be accepted. Which projects should Adamson accept? Project 1 Project 2 -Select- -Select- Project 3 -Select- Project 4 -Select-

Answer 1

Solution a
Cost of individual components
Cost of debt	10%
Tax rate	25%
After-tax cost of debt	=10%*(1-25%)
The after-tax cost of debt	7.50%
Preference dividend	$            6.00
Share price	$          45.00
Cost of preference stock	6/45
Cost of preference stock	13.33%
Equity share price	$          38.00
Net dividend-D1=	$            4.25
Dividend growth rate	5%
Share price=	Next dividend/(Cost of equity-growth rate)
38=	4.25/(Cost of equity-5%)
(Cost of equity-5%)=	4.25/38
(Cost of equity-5%)=	11.18%
Cost of equity=	16.18%
Solution b
Calculation of WACC
	Cost	Weight	Weighted cost
	A	B	C=A*B
Debt	7.50%	15.00%	1.13%
Preferred stock	13.33%	10.00%	1.33%
Equity stock	16.18%	75.00%	12.14%
	Total capital	Total WACC	14.60%
Solution C
Project	Return	WACC	Selection
1	16.00%	14.60%	Selected
2	15.00%	14.60%	Selected
3	13.75%	14.60%	Rejected
4	12.50%	14.60%	Rejected