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 rd = 10%, and its tax rate is 40%. It can issue preferred stock that pays a constant dividend of $4 per year at $45 per share. Also, its common stock currently sells for $38 per share; the next expected dividend, D1, is $4.50; 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. 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 % What is Adamson's WACC? Round your answer to two decimal places. Do not round your intermediate calculations. % Only projects with expected returns that exceed WACC will be accepted. Which projects should Adamson accept? Project 1 Project 2 Project 3 Project 4

Answer 1

The after tax cost of debt is :

= Cost of debt ( 1 - tax rate)

= 10% * 0.6

= 0.06

The cost of common equity is :

Re = D1/Po + g

= 4.5/38 + 0.05

=0.1684

The cost of preference shares:

= Dividend/ cost of preference share

= $4/$45

=0.0889

The WACC is :

weight of debt* after tax cost of debt + weight of equity*cost of equity + weight of preference shares*cost of preference shares

= 0.15* 0.06 + 0.75*0.1684 + 0.10*0.0889

=0.009 + 0.1263 + 0.0089

=14.4190

= 14.42% (rounded off to two decimal places)

As, projects 1 and 2 have discount rates, greater than the WACC , we should accept both of these projects.

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