WACC and optimal capital budget Adamson Corporation is considering four average-

Question

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 rd = 11%, and its tax rate is 35%. It can issue preferred stock that pays a constant dividend of $4 per year at $47 per share. Also, its common stock currently sells for $33 per share; the next expected dividend, D1, is $4.00; and the dividend is expected to grow at a constant rate of 4% 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. Do not round your intermediate calculations. Cost of debt % Cost of preferred stock % Cost of retained earnings % What is Adamson's WACC? Round your answer to two decimal places. Do not round your intermediate calculations. % Only projects with expected returns that exceed WACC will be accepted. Which projects should Adamson accept? Project 1 Project 2 Project 3 Project 4

Explanation / Answer

Post tax Cost of Debt = Pretax cost of debt * (1 - Tax Rate) = 11% * (1 - 35%) = 7.15%

Cost of preferred stock = Annual dividend/Current price = 4/47 = 8.51%

Cost of common stock (based on dividend discount model) = (Expected dividend/Current price) + Growth = (4/33) + 4% = 16.12%

WACC = Weight of debt * Psot tax cost of debt + Weight of preferred equity * Cost of preferred equity + Weight of common equity * Cost of common equity

WACC = (15% * 7.15%) + (10% * 8.51%) + (75% * 16.12%) = 14.01%

Since rate of return is higher in case of Project 1 and 2 (from WACC), select those two projects.

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