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 = 11%, and its tax rate is 25%. It can issue preferred stock that pays a constant dividend of $7.00 per year at $57.00 per share. Also, its common stock currently sells for $51.00 per share; the next expected dividend, D₁, is $4.75; 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.

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.

     %

3. 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-AcceptRejectItem 8

Answer 1

a. cost of debt is computed as follows:

= rd x (1 - tax rate)

= 11% x (1 - 0.25)

= 8.25%

cost of preferred stock is computed as follows:

= Dividend / Price

= $ 7 / $ 57

= 12.28070175% or 12.28% Approximately

Cost of retained earnings is computed as follows:

= (D1 / P0) + growth rate

= ($ 4.75 / $ 51) + 6%

= 15.31372549% or 15.31% Approximately

b. WACC is as follows:

= cost of debt x weight of debt + cost of preferred stock x weight of preferred stock + cost of retained earnings x weight of retained earnings

= 8.25% x 15% + 12.28070175% x 10% + 15.31372549% x 75%

= 13.95%

c. So, the projects that shall be accepted will be as follows:

Project 1 and Project 2 (Since rate of return exceeds WACC)

Projects that shall be rejected will be as follows:

Project 3 and Project 4 (Since rate of return is less than WACC)

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