Question

Adamson Corporation is considering four average-risk projects with the following costs and rates of return: Project...

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 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.

  1. What is the cost of each of the capital components? Do not round intermediate calculations. Round your answers to two decimal places.

    Cost of debt: ? %

    Cost of preferred stock: ? %

    Cost of retained earnings: ? %

  2. What is Adamson's WACC? Do not round intermediate calculations. Round your answer to two decimal places.

    ? %

  3. Only projects with expected returns that exceed WACC will be accepted. Which projects should Adamson accept?

    Project 1 -Select-Accept/Reject
    Project 2 -Select-Accept/Reject
    Project 3 -Select-Accept/Reject
    Project 4 -Select-Accept/Reject

Homework Answers

Answer #1

Cost of capital components will be as follows:

Debt = rd*(1-tax rate)

= 9%*(1-25%)

= 6.75%

Cost of Preferred Stock = Annual Dividend/Price per share

= 6/53

= 11.32%

Price of Common Stock = Expected Dividend/(Cost of Equity – growth rate)

38 = 4.25/(Cost of Equity – 5%)

Cost of Equity = 16.18%

WACC = Cost of Debt*Weight of Debt + Cost of Preferred Stock*Weight of Preferred Stock + Cost of Equity*Weight of Equity

= 6.75%*15% + 11.32%*10% + 16.18%*75%

= 14.2795%

i.e. 14.28%

The projects whose IRR exceeds WACC to be selected

I.e. Project 1 – Accept

Project 2 – Accept

Project 3 – Reject

Project 4 – Reject

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