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 rd = 9%, and its tax rate is 35%. It can issue preferred stock that pays a constant dividend of $4 per year at $51 per share. Also, its common stock currently sells for $34 per share; the next expected dividend, D1, is $4.00; 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. 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. Open spreadsheet 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

First we should find out the rate of each instrument/source.

1. Rate of Debt (R_d) = 9% , Tax rate = 35%.

So, Effective rate of Debt = 9% - tax 35% = 5.85%

2. rate of preferred stock (R_p) = Dividend/ Share price = 4 / 51 = 7.843%

3. rate of Common stock (R_s) = Dividend / Share price + growth = 4/ 34 + 0.05 = 16.764%

Now, the WACC of Adamson Corp = Weight of Debt * R_d + Weight of Preferred stock * R_p + Weight of Common stock * R_s = 0.15 * 5.85 % + 0.10 * 7.843% + 0.75 * 16.764 % = 14.24%

WACC = 14.24%

Projects with Return greater then WACC are accepted.

So, WACC = 14.24 %

Project 1 with 16% and Project 2 with 15% are accepable by Adamson .