Problem 10-18 WACC and optimal capital budget Adams Corporation is considering f

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:

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 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

Explanation / Answer

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

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.

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%

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