Question

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 = 10%, and its tax rate is 35%. It can issue preferred stock that pays a constant dividend of $3 per year at $52 per share. Also, its common stock currently sells for $36 per share; the next expected dividend, D₁, is $3.75; 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	-Select-accept rejectItem 5
   Project 2	-Select-accept rejectItem 6
   Project 3	-Select-accept rejectItem 7
   Project 4	-Select-accept rejectItem 8

Answer 1

a.

Cost of debt = 10%

Cost of equity (retained earnings)

As per DDM

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

36 = 3.75/ (Cost of equity - 0.07)

Cost of equity% = 17.42

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

After tax cost of debt = 10*(1-0.35)

= 6.5

cost of preferred equity

cost of preferred equity = Preferred dividend/price*100

cost of preferred equity = 3/52*100

=5.77

b

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

WACC=6.5*0.15+17.42*0.75+5.77*0.1

WACC =14.62%

c

Accept only project 1 & 2 as they have return higher than WACC