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 rd = 9%, and its tax rate is 25%. It can issue preferred stock that pays a constant dividend of $5.00 per year at $50.00 per share. Also, its common stock currently sells for $33.00 per share; the next expected dividend, D1, is $4.25; 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. What is the cost of each of the capital components? Do not round intermediate calculations. Round your answers to two decimal places. Cost of debt: % Cost of preferred stock: % Cost of retained earnings: % What is Adamson's WACC? Do not round intermediate calculations. Round your answer to two decimal places. % 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 capital components will be as follows:

Debt = rd*(1-tax rate)

= 9%*(1-25%)

= 6.75%

Cost of Preferred Stock = Annual Dividend/Price per share

= 5/50

= 10%

Price of Common Stock = Expected Dividend/(Cost of Equity – growth rate)

33 = 4.25/(Cost of Equity – 4%)

Cost of Equity = 16.88%

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

= 6.75%*15% + 10%*10% + 16.88%*75%

= 14.6725%

i.e. 14.67%

The projects whose IRR exceeds WACC to be selected

I.e. Project 1 – Accept

Project 2 – Accept

Project 3 – Reject

Project 4 – Reject