Question

WACC and optimal capital budget Adamson Corporation is considering four average-risk projects with the following costs and rates of return: Project Cost Expected Rate of Return $2,000 16.00% 3,000 15.00 5,000 13.75 2,000 12.50 The company estimates that it can issue debt at a rate ofre -10%, and its tax rate is 30%. It can issue preferred stock that pays a constant dividend of $4 per year at $42 per share. Also, its common stock currently sells for $37 per share; the next expected dividend, D1, is $3.75; and the dividend is expected to grow at a constant rate of 7% 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? Round your answers to two decimal places. Do not round your intermediate calculations Cost of debt Cost of preferred stock Cost of retained earnings b. What is Adamson's WACC Round your answer to two decimal places. Do not round your intermediate calculations c. Only projects with expected returns that exceed WACC will be accepted. Which projects should Adamson accept? Project 1 Project 2 -Select- Project 3 Project 4 Select

Answer 1

Given:

Rate of Debt = 10%

Tax Rate = 30%

Cost of Debt = 10%(1-0.30) = 7%

Given

Dividend for preferred stock = $4

Price of Stock = $42

Cost of Preferred Stock = 4/42 = 0.0952 = 9.52%

Given

Price of Equity P₀ = $37

Dividend D₁ = $ 3.75

Growth g = 7%

Cost of Retained earning = D/P+g = 3.75/37+0.07 = 0.1714 = 17.14%

b. Calculation of Weighted Average cost of capital

Particulars	After tax cost	Weight	WAC
Debt	0.07	0.15	0.0105
Preferred Stock	0.0952	0.10	0.00952
Common Stock	0.1714	0.75	0.12855
			0.14857

Weighted Average cost of capital = 14.86%

C. Project 1 & 2 should be accepted.