Question

Problem 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	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 = 11%, and its tax rate is 40%. It can issue preferred stock that pays a constant dividend of $6 per year at $42 per share. Also, its common stock currently sells for $40 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? Round your answers to two decimal places.
   Cost of debt  %
   Cost of preferred stock  %
   Cost of retained earnings  %
   
2. What is Adams' WACC? Round your answer to two decimal places.
   %
   
3. Only projects with expected returns that exceed WACC will be accepted. Which projects should Adams accept?

   Project 1	-Select-acceptrejectItem 5
   Project 2	-Select-acceptrejectItem 6
   Project 3	-Select-acceptrejectItem 7
   Project 4	-Select-acceptrejectItem 8

Answer 1

Cost of capital components will be as follows:

Debt = rd*(1-tax rate)

= 11%*(1-40%)

= 6.6%

Cost of Preferred Stock = Annual Dividend/Price per share

= 6/42

= 14.29%

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

40 = 4.75/(Cost of Equity – 4%)

Cost of Equity = 15.875%

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

= 6.6%*15% + 14.29%*10% + 15.875%*75%

= 14.32525%

i.e. 14.33%

The projects whose IRR exceeds WACC to be selected

I.e. Project 1 – Accept

Project 2 – Accept

Project 3 – Reject

Project 4 – Reject