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 = 11%, and its tax rate is 25%. It can issue preferred stock that pays a constant dividend of $4.00 per year at $51.00 per share. Also, its common stock currently sells for $36.00 per share; the next expected dividend, D1, is $4.25; 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.

a. 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:-------- % ?

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

---------% ?

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

Project 1 Accept or Reject ?

Project 2 Accept or Reject ?

Project 3    Accept or Reject ?

Project 4    Accept or Reject ?

Answer 1

a. Cost of debt = Rd(1-Tax) = 11%(1-25%)= 8.25%

Cost of preferred stock = Dividend/ Stock price = 4/51 = 7.84%

Cost of retained earnings = Dividend/ Stock price + Growth rate = 4.25/ 36 +5% =  16.81%

b. WACC = 14.63%

	Weights	Cost of capital
	(a)	(b)	(a)*(b)
Common stock	0.75	16.81%	12.60%
Debt	0.15	8.25%	1.24%
Preferred stock	0.1	7.84%	0.78%
WACC			14.63%

c. For a project to be accepted the required rate of returm must be higher than WACC

Project 1	Accept
Project 2	Accept
Project 3	Reject
Project 4	Reject