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) = (D₁/P₀) + 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.