Question

Adamson Corporation is considering four average-risk projects with the following costs and rates of return: Project...

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 ?

Homework Answers

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

  

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