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 = 9%, and its tax rate is 35%. It can issue preferred stock that pays a constant dividend of $4 per year at $52 per share. Also, its common stock currently sells for $38 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. 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

a)

After-tax cost of debt (rd) = rate * (1-tax rate) = 0.09*(1 – 0.35) = 0.0585 (5.85%)

Cost of preferred stock (rp) = dividend/stock = $4.00 / $52.00 = 0.0769 (7.69%)

Cost of common stock (rs) = dividend/stock + dividend growth rate= $4.00 / $38.00 + 0.07 = 0.1752 (17.52%)

b) WACC = wd(rd)(1 – T) + wp(rp) + ws(rs)

WACC = 0.15(0.0585) + 0.10(0.0769) + 0.75(0.1752) = .1478 or 14.78%

c) Adams Corporation should accept projects 1 and 2, since their expected rates of return exceed the firm’s WACC

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