Question

Subject WACC AND OPTIMAL CAPITAL BUDGET

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 = 9%, and its tax rate is 30%. It can issue preferred stock that pays a constant dividend of $6 per year at $52 per share. Also, its common stock currently sells for $35 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	accept or reject?
   Project 2	accept or reject?
   Project 3	accept or reject?
   Project 4	accept or reject?

Answer 1

Cost of capital components will be as follows:

Debt = rd*(1-tax rate)

= 9%*(1-30%)

= 6.3%

Cost of Preferred Stock = Annual Dividend/Price per share

= 6/52

= 11.54%

Price of Common Stock = Expected Dividend/(Cost of Equity – growth rate)

35 = 3.50/(Cost of Equity – 7%)

Cost of Equity = 17%

WACC = Cost of Debt*Weight of Debt + Cost of Preferred Stock*Weight of Preferred Stock + Cost of Equity*Weight of Equity

= 6.3%*15% + 11.54%*10% + 17%*75%

= 14.849%

i.e. 14.85%

The projects whose IRR exceeds WACC to be selected

I.e. Project 1 – Accept

Project 2 – Accept

Project 3 – Reject

Project 4 – Reject