Question

Subject WACC AND OPTIMAL CAPITAL BUDGET Adamson Corporation is considering four average-risk projects with the following...

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 rd = 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?

Homework Answers

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

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