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 = 10%, and its tax rate is 30%. It can issue preferred stock that pays a constant dividend of $5 per year at $58 per share. Also, its common stock currently sells for $37 per share; the next expected dividend, D₁, is $4.75; and the dividend is expected to grow at a constant rate of 4% 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-AcceptReject
   Project 2	-Select-AcceptReject
   Project 3	-Select-AcceptReject
   Project 4	-Select-AcceptReject

Answer 1

a.Cost of Debt = rd*(1-Tax rate)

= 10%*(1-30%)

= 7%

Cost of preferred Stock = Annual Dividend/Share Price

= 5/58

= 8.62%

Share Price = D1/(Cost of Retained Earnings – Growth rate)

37 = 4.75/(Cost of Retained Earnings – 4%)

Cost of Retained Earnings = 16.84%

WACC = Cost of Debt*Weight of Debt + Cost of Preferred Stock*Weight of Preferred Stock + Cost of Retained Earnings*Weight of retained earnings

= 7%*15% + 8.62%*10% + 16.84%*75%

= 14.542%

i.e. 14.54%

Projects 1 and 2 will be accepted since return is higher than WACC

Project 1 – Accept

Project 2 – Accept

Project 3 – Reject

Project 4 – Reject