Question

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 r_d = 10%, and its tax rate is 40%. It can issue preferred stock that pays a constant dividend of $3 per year at $54 per share. Also, its common stock currently sells for $34 per share; the next expected dividend, D₁, is $4.25; 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. The data has been collected in the Microsoft Excel Online file below. Open the spreadsheet and perform the required analysis to answer the questions below.

Open spreadsheet

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

Project 2

Project 3

Project 4

Answer 1

a

Cost of equity

As per DDM

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

34 = 4.25/ (Cost of equity - 0.05)

Cost of equity% = 17.5

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

After tax cost of debt = 10*(1-0.4)

= 6

cost of preferred equity

cost of preferred equity = Preferred dividend/price*100

cost of preferred equity = 3/54*100

=5.56

b

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

WACC=6*0.15+17.5*0.75+5.56*0.1

WACC =14.58%

c

Accept project 1 and 2 as expected return for them is more than WACC