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 40%. It can issue preferred stock that pays a constant dividend of $6 per year at $60 per share. Also, its common stock currently sells for $38 per share; the next expected dividend, D₁, is $3.50; and the dividend is expected to grow at a constant rate of 7% 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? Round your answers to two decimal places. Do not round your intermediate calculations.

   Cost of debt %

   Cost of preferred stock %

   Cost of retained earnings %

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

   %

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

   Project 1	_______acceptreject
   Project 2	_______acceptreject
   Project 3	_______acceptreject
   Project 4

Answer 1

1-
After tax cost of debt	cost of debt*(1-tax rate)	10*(1-.4)	6%
cost of preferred stock	preferred dividend/market price	6/60	10%
cost of common equity	(expected dividend/market price)+growth rate	(3.5/38)+7%	16.21%
2-
WACC
source	weight	component cost	weight*component cost
debt	0.15	6	0.9
preferred stock	0.1	10	1
common equity	0.75	16.21	12.1575
WACC = sum of weight*component cost			14.06
3-
Project	Expected return	WACC	Expected rate of return>WACC Accept the project, expected rate of return<WACC reject
1	16%	14.06%	Accept
2	15%	14.06%	Accept
3	13.75%	14.06%	reject
4	12.50%	14.06%	reject