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 = 11%, and its tax rate is 35%. It can issue preferred stock that pays a constant dividend of $3 per year at $48 per share. Also, its common stock currently sells for $32 per share; the next expected dividend, D1, is $3.75; and the dividend is expected to grow at a constant rate of 6% 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 Project 2 Project 3 Project 4

Answer 1

Before tax cost of debt = 11%

Tax rate = 35%

after tax cost of debt = 11% × (1 - 35%)

= 7.15%

After tax cost of debt is 7.15%.

Cost of preferred stock = $3 / $48

= 6.25%

Cost of preferred stock is 6.25%.

Cost of equity = ($3.75 / $32) + 6%

= 11.72% + 6%

= 17.72%

Cost of equity is 17.72%.

Now, WACC is calculated below:

WACC = (75% × 17.72) + (15% × 7.15%) + (10% × 6.25%)

= 13.29% + 0.63% + 1.07%

= 14.99%

WACC of company is 14.99%.

Now,

Company accept Only projects with expected returns that exceed WACC will be accepted. Expected rate of return of project 1 is higher than WACC. So, project 1 should be accepted.