Question

**Problem 10-18**

WACC and optimal capital budget

Adams 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 30%. It can issue preferred stock that pays a constant dividend of $3 per year at $60 per share. Also, its common stock currently sells for $40 per share; the next expected dividend, D1, is $4.00; 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.

What is the cost of each of the capital components? Round your
answers to two decimal places.(fill the answers in the
blanks)

Cost of debt **______**%

Cost of preferred stock **_______**%

Cost of retained earnings **______**%

What is Adams' WACC? Round your answer to two decimal
places.

**________**%

Only projects with expected returns that exceed WACC will be accepted. Which projects should Adams accept? (select accept OR reject for the following questions)

Project 1 | Accept or Reject |

Project 2 | Accept or Reject |

Project 3 | Accept or Reject |

Project 4 | Accept or Reject |

Answer #1

Cost of debt = Interest ( 1 - Tax rate )

= 10% ( 1 - 0.30)

= 7%

Cost of preferred stock = Dividend/ Issue price

= 3/60

= 5%

Cost of common stock(Cost of retained earnings) =
(D_{1}/P_{0}) + g

= (4/40) + 0.07

= 0.10 + 0.07

= 0.17

= 17%

Calculation of WACC

Fund | Cost | Weight | Cost x Weight |

Debt | 7% | 0.15 | 7% x 0.15 = 1.05% |

Preferred stock | 5% | 0.10 | 5% x 0.10 = 0.50% |

Retained earnings | 17% | 0.75 | 17% x 0.75 = 12.75% |

WACC = 14.30% |

Project | Expected rate of return | WACC | Accept/Reject |

Project 1 | 16% | 14.30% | Accept |

Project 2 | 15% | 14.30% | Accept |

Project 3 | 13.75% | 14.30% | Reject |

Project 4 | 12.50% | 14.30% | Reject |

Since the expected rate of return of project 1 and project 2 is more than WACC, hence project 1 and project 2 will be accepted. Project 3 and project 4 will be rejected since their expected rate of return is less than WACC.

Problem 10-18
WACC and optimal capital budget
Adams 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 = 11%, and its tax rate is 40%. It can issue
preferred stock that pays a constant dividend of $6 per year at $42
per share. Also,...

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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...

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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 35%. It can issue
preferred stock that pays a constant dividend of $3 per year at $52
per share. Also, its common...

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1 $2,000 16.00%
2 3,000 15.00
3 5,000 13.75
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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
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with the following costs and rates of return:
Project
Cost
Expected Rate of
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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 40%. It can issue preferred stock that pays
a constant dividend of $6 per year at $42 per share. Also, its
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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 35%. It can issue preferred
stock that pays a constant dividend of $6 per year at $49 per
share. Also, its common...

Excel Online Structured Activity: 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 = 10%, and its tax rate is 40%. It can issue
preferred stock that pays a constant dividend of $3 per year at $54
per...

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 $42
per share. Also, its common stock currently sells for $36...

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 25%. It can issue preferred
stock that pays a constant dividend of $6.00 per year at $53.00 per
share. Also, its common stock currently sells for $38.00...

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