Question

WACC AND OPTIMAL CAPITAL BUDGET

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 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 $33 per share; the next expected dividend, D1, is $3.75; and the dividend is expected to grow at a constant rate of 5% 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? Round your answers to two decimal places. Do not round your intermediate calculations.
Cost of debt %
Cost of preferred stock %
Cost of retained earnings %

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

Only projects with expected returns that exceed WACC will be accepted. Which projects should Adamson accept?

Project 1	-Select-AcceptRejectItem 5
Project 2	-Select-AcceptRejectItem 6
Project 3	-Select-AcceptRejectItem 7
Project 4	-Select-AcceptReject Item 8

Answer 1

Cost of Prefered Stock = $6/$42 = 14.28%

Cost of Debt = 9%

Cost of Debt after tax = 9% (1-.40)

Cost of Debt after tax = 5.4%

Cost of Common Stock = K_e

K_e = (D₁ / P₀) + g

P₀ = Current Market Price = $33.00

D₁ = Dividend of current year = $3.75

Ke = Cost of Equity = ?

g = Growth Rate = 5%

K_e = ($3.75/ $33) + .05

K_e = 16.36%

WACC =(Cost of Debt after Tax * Percent of debt to total capital) +

(Cost of Prefered Stock * Percent of Prefered Stock to total capital) +

(Cost of Common Stock * Percent of common stock to total capital)

WACC = (5.4 * 15%) + (14.28 * 10%) + (16.36 * 75%)

WACC = 0.81%+ 1.428%+12.27%

WACC = 14.51%

Project 1 & 2 to be accepted as they have higher expected return than WACC.