Question

y: 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% 15.00 2 3 ,000 5,000 13.75 2,000 12.50 The company estimates that it can issue debt at a rate ofre=11%, and its tax rate is 40%. It can issue preferred stock that pays a constant dividend of $6 per year at $56 per share. Also, its common stock currently sells for $31 per share the next expected dividend, D is $3.75; and the dividend is expected to grow at a constant rate of 4% per year. The target capital structure consists of 75% common stock, 15% debt, and 10% preferred stock. The data has been collected in the Microsoft Excel Online file below. Open the spreadsheet and perform the required analysis to answer the questions below. Open spreadsheet 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 Project 3 Project 4

Answer 1

Cost of debt	11%
Tax rate	40%
After-tax cost of debt	=11%*(1-40%)
The after-tax cost of debt	6.60%
Pref dividend	$                               6.00
Pref share price	$                             56.00
Cost of Pref share	6/56
Cost of Pref share	10.71%
Market price per share	$                             31.00
Expected dividend	$                               3.75
Growth rate	4%
Share price=	Expected dividend/(Cost - Growth)
31=	3.75/(Cost - 4%)
Cost - 4%=	3.75/31
Cost - 4%=	0.120967742
Cost=	16.10%
Calculation of WACC
	Cost	Weight	Weighted cost
	A	B	C=A*B
Debt	6.60%	15.00%	0.99%
Pref capital	10.71%	10.00%	1.07%
Equity	16.10%	75.00%	12.07%
		Total WACC	14.13%
Project acceptance analysis
Project	Cost	Expected return	Cost	Project accpetance	Criteria
1	$                             2,000	16.00%	14.13%	Yes	IF(Expected return > WACC,"Yes","No")
2	$                             3,000	15.00%	14.13%	Yes	IF(Expected return > WACC,"Yes","No")
3	$                             5,000	13.75%	14.13%	No	IF(Expected return > WACC,"Yes","No")
4	$                             2,000	12.50%	14.13%	No	IF(Expected return > WACC,"Yes","No")