WACC and optimal capital budget Adams Corporation is considering four average-ri

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WACC and optimal capital budget
Adams 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 = 10%, and its tax rate is 35%. It can issue preferred stock that pays a constant dividend of $4 per year at $59 per share. Also, its common stock currently sells for $31 per share; the next expected dividend, D1, is $3.25; and the dividend is expected to grow at a constant rate of 6% 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? Round your answers to two decimal places.

Cost of debt ___________________%

Cost of preferred stock __________%

Cost of retained earnings ________%

2. What is Adams' WACC? Round your answer to two decimal places.
______%

Explanation / Answer

We have D1=3.25, g=4%, P0=30
Using DCF, (GORDON MODEL) The constant dividend growth model:
we have P0=D1/(Ks-g) or Ks = D1/P0 +g
where:
D1 = next year’s dividend
g = firm’s constant growth rate
P0 = price
Ks = Cost of retained earnings (ks) is the return stockholders require on the company’s common stock.

ie Cost of Equity Ks = 3.25/30 +4% = 14.83%..............Ans (c)

Kp = preferred stock dividend/market price of preferred stock
Cost of Pref stock Kp= D/P = 3/40 = 7.50%..........Ans (b)

COST OF DEBT (Kd)
We use the after tax cost of debt because interest payments are tax deductible for the firm.
Kd after taxes = Kd (1 – tax rate)
Cost of Debt Kd = (1-T)* Debt rate = (1-30%)*10% = 7%.......Ans (a)

The firm’s WACC is the cost of Capital for the firm’s mixture of debt and stock in their capital structure.
WACC = wd (cost of debt) + ws (cost of stock/RE) + wp (cost of pf. stock)
wd = weight of debt (i.e. fraction of debt in the firm’s capital structure)
ws = weight of stock
wp = weight of prefered stock
So WACC = Wd*Kd + Ws*Ks +Wp*Kp
ie WACC = 15%*7% + 75%*14.83% + 10%*7.5% = 12.92%.....Ans (d)

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