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
1	$2,000	16.00%
2	3,000	15.00
3	5,000	13.75
4	2,000	12.50

The company estimates that it can issue debt at a rate of r_{d}=9 %, and its tax rate is 40 %. It can issue preferred stock that pays a constant dividend of $4 per year at $57 per share. Also, its common stock currently sells for $34 per share; the next expected dividend, D_{i}, is 43.25; 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.

Answer 1

rate positively ..

Ans a)	Computation of cost of capital
	cost of debt=		5.40%
	9*(1-40%)
	Ans =		5.40%
	Cost of preferred stock
	annual dividend/Price today		7.02%
	4/57
	Cost of retained earning
	using DDM we can compute the cost of retained earning
	Cost =	Dividend next year/Price today + growth rate
		3.25/34+7%
		16.56%
	ans =		16.56%
Ans b)	Computation of WACC
	Source	weight	cost	Weight*cost
	cost of debt=	15%	5.40%	0.81%
	Cost of preferred stock	10%	7.02%	0.70%
	Cost of retained earning	75%	16.56%	12.42%
				13.93%
	ans =			13.93%
Ans c)		Answer
	Project 1	ACCEPT
	Project 2	ACCEPT
	Project 3	REJECT
	Project 4	REJECT