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 = 11%, and its tax rate is 40%. It can issue preferred stock that pays a constant dividend of $5 per year at $40 per share. Also, its common stock currently sells for $30 per share; the next expected dividend, D₁, is $3.50; and the dividend is expected to grow at a constant rate of 5% 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. ______%

Answer 1

a.

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 11*(1-0.4)

= 6.6

cost of preferred equity

cost of preferred equity = Preferred dividend/price*100

cost of preferred equity = 5/40*100

=12.5

As per DDM

Price = Dividend in 1 year* (1 + growth rate )/(cost of equity - growth rate)

30 = 3.5/ (Cost of equity - 0.05)

Cost of equity% = 16.67

b.

Weight of equity = E/A

Weight of equity =

W(E)=0.75

Weight of debt = D/A

Weight of debt = 0.15

W(D)=0.15

Weight of preferred equity =1-D/A-E/A

Weight of preferred equity = =1-0.15 - 0.75

W(PE)=0.1

WACC=after tax cost of debt*W(D)+cost of equity*W(E)+Cost of preferred equity*W(PE)

WACC=6.6*0.15+16.67*0.75+12.5*0.1

WACC% = 14.74