Question

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 = 10%, and its tax rate is 30%. It can issue preferred stock that pays a constant dividend of $5 per year at $57 per share. Also, its common stock currently sells for $40 per share; the next expected dividend, D₁, is $4.00; and the dividend is expected to grow at a constant rate of 6% 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.

- 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 __%

- What is Adamson's WACC? Round your answer to two decimal places. Do not round your intermediate calculations. __%

- Only projects with expected returns that exceed WACC will be accepted. Which projects should Adamson accept?

Project 1	_______accept/reject
Project 2	_______accept/reject
Project 3	_______accept/reject
Project 4	_______accept/reject

Answer 1

Cost of Debt = Before tax cost(1-Tax rate)

= 10%(1-30%)

= 7%

Value of preferred Stock = Annual Dividend/Return

57 = 5/Return

Return = 8.77%

Value of Common Stock = Next dividend/(Return – growth rate)

40 = 4/(Return – 6%)

Return = 16%

WACC = Cost of Debt*Weight of Debt + Cost of Preferred Stock*Weight of Preferred Stock + Cost of Equity*Weight of Equity

= 7%*15% + 8.77%*10% + 16%*75%

= 13.927%

i.e. 13.93%

Project 1 – Accept

Project 2 – Accept

Project 3 – Reject

Project 4 – Reject