Question

Project Cost Expected Rate of Return 1 $2,000 16.00% 2 3,000 15.00 3 5,000 13.75 4...

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 = 11%, and its tax rate is 35%. It can issue preferred stock that pays a constant dividend of $4 per year at $56 per share. Also, its common stock currently sells for $31 per share; the next expected dividend, D1, is $3.25; and the dividend is expected to grow at a constant rate of 7% 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.

Cost of debt, rd 11.00%
Tax rate, T 35.00%
Preferred dividend $4.00
Preferred stock price, Pp $56.00
Common stock price, P0 $31.00
Expected common dividend, D1 $3.25
Common stock constant growth rate, gn 7.00%
% common stock in capital structure 75.00%
% debt in capital structure 15.00%
% preferred stock in capital structure 10.00%
Cost of capital components
& WACC calculation:
Weights After-tax Cost Weighted Cost
After-tax cost of debt, rd(1 – T) 15.00%
Cost of preferred stock, rp 10.00%
Cost of common stock, rs 75.00%
Project acceptance analysis:
Projects Cost Expected Rate of Return Accept Project? Y/N
1 $2,000 16.00%
2 $3,000 15.00%
3 $5,000 13.75%
4 $2,000 12.50%
Cost of capital components
& WACC calculation:
Weights After-tax Cost Weighted Cost
After-tax cost of debt, rd(1 – T) 15.00% #N/A #N/A
Cost of preferred stock, rp 10.00% #N/A #N/A
Cost of common stock, rs 75.00% #N/A #N/A
WACC = #N/A
Projects Cost Expected Rate of Return Accept Project? Y/N
1 $2,000 16.00% #N/A
2 $3,000 15.00% #N/A
3 $5,000 13.75% #N/A
4 $2,000 12.50% #N/A

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 %

Homework Answers

Answer #1

1. after tax cost of debt=cost of debt*(1-tax rate)=11%*(1-35%)=7.15%

Weighted cost of debt=Weight of debt*after tax cost of debt=15%*7.15%=1.0725%

Cost of preferred stock=annual dividend/price of preferred stock=4/56=7.14%

weighted cost of preferred stock=weight of preferred stock*cost of preferred stock=10%*7.14%=0.714%

Cost of common stcok=(Dividend next year/common share price)+growth rate=(3.25/31)+7%=17.48%

Weight cost of common stock=weight of common stock*cost of common stock=75%*17.48%=13.11%

WACC=Weighted cost of debt+weighted cost of preferred stock+Weight cost of common stock=1.0725%+0.714%+13.11%=14.90%

2.

Cost Expected rate of return Accept Project? Remarks
Project1 2000 16% Yes Expected rate>WACC
Project2 3000 15% Yes Expected rate>WACC
Project3 5000 13.75% No Expected rate<WACC
Project4 2000 12.50% No Expected rate<WACC
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