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 = 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 $36.00 per share; the next expected dividend, D₁, is $4.75; 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.

1. 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:

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

Answer 1

Sol :

a) To determined cost of each of the capital components as follows,

i) Debt rate (rd) = 9%

Tax rate = 25%

Cost of debt = rd x (1-tax rate)

Cost of debt = 9% x (1-25%)

Cost of debt = 0.09 x 0.75 = 6.75%

ii) Dividend = $5

Preferred stock price = $50

Cost of preferred stock = Dividend/Price

Cost of preferred stock = 5/50

Cost of preferred stock = 10%

iii) Expected dividend for common sharea (D1) = $4.75

Common stock price (Cp) = $36

Dividend growth (g) = 4%

Cost of retained earnings: = D1/CP + g

Cost of retained earnings: = 4.75/36 + 4%

Cost of retained earnings: = 13.19% + 4% = 17.19%

Cost of retained earnings: = 17.19%

b) WACC = Cost of equity x %equity + Cost of debt x %debt x (1-tax rate) + Cost of preferred stock x %preferred stock

WACC = 17.19% x 75% + 6.75% x 15% + 10% x 10%

WACC = 12.89% + 1.01% + 1%

WACC = 14.90%