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 r_d = 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

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