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 $4 per year at $42 per share. Also, its common stock currently sells for $36 per share; the next expected dividend, D₁, is $4.00; and the dividend is expected to grow at a constant rate of 6% 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 / Reject
   Project 2	Accept / Reject
   Project 3	Accept / Reject
   Project 4	Accept / Reject

Answer 1

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

= 10%*(1-40%)

= 6%

Cost of preferred Stock = Annual Dividend/Share Price

= 4/42

= 9.52%

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

36 = 4/(Cost of Retained Earnings – 6%)

Cost of Retained Earnings = 17.11%

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

= 6%*15% + 9.52%*10% + 17.11%*75%

= 14.6845%

i.e. 14.68%

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