Question

10-18 WACC and optimal capital budget Adams Corporation is considering four average-risk projects with the following costs and rates of return: Project Cost Expected Rate of Return 1 $2,000 50% 2 3,000 40 3 5,000 30 4. 2,000 20 The company estimates that it can issue debt at a before-tax-cost of rd=5%, and its tax rate is 30 percent. The company also can issue preferred stock a $100 per share, which pays a constant dividend of $5 per year. The company's common stock currently sells at $40 per share. The year-end dividend, D1, is expected to be $5.00, and the dividend is expected to grow at a constant rate of 5 percent per year. The company's capital structure consists of 50 percent common stock, 40 percent debt, and 10 percent preferred stock. (30 points) 1. What is the cost of each of the capital components? 2. What is Adam's WACC 3. Which projects should Adams accept?

Answer 1

1.

• Before tax cost of Debt (r_d) = 5%

Tax rate = 30%

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

= 5(1-0.30)

= 3.5%

• Cost of Preferred Stock = Annual Dividends/Value of Preferred Stock
  = $5/$100
  = 5%
  
• Cost of Equity = (D₁/P₀)+g
  = (5/40) + 0.05
  = 17.5%

2.).

WACC= (Weight of Debt)(Cost of Debt)+ (Weight of Preferred Stock)(Cost of Preferred Stock) (Weight of Equity)(Cost of Equity)

WACC = (0.40)(3.5%) + (0.10)(5%) + (0.50)(17.5%)

WACC = 1.4% + 0.50% + 8.75%

WACC = 10.65%

3). Project Adam should accept:-

Project	Cost	Expected rate of return	WACC	Return after WACC	Amount of Return
1	$2000	50%	10.65%	39.35%	$787
2	$3000	40%	10.65%	29.35%	$880.5
3	$5000	30%	10.65%	19.35%	$967.5
4	$2000	20%	10.65%	9.35%	$187

Since, Project 3 provides better after amount of return on cost. Hence, Project 3 should be chosen.