10-18 WACC AND OPTIMAL CAPITAL BUDGET Adamson Corporaton average-risk projects w
ID: 2805402 • Letter: 1
Question
10-18 WACC AND OPTIMAL CAPITAL BUDGET Adamson Corporaton average-risk projects with the following costs and rates of return: is considering four Project Cost $2,000 3,000 5,000 2,000 Expected Rate of Return 16.00% 15.00 13.75 12.50 2 The company estimates that it can issue debt at a rate of ra = 10%, and its tax rate is 30%. It can issue preferred stock that pays a constant dividend of $5.00 per year at $50.00 per share. Also, its common stock currently sells for $38.00 per share; the next expected dividend, Dy, is $425, 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. a. What is the cost of each of the capital components? b. What is Adamson's WACC? c. Only projects with expected returns that exceed WACC will be accepted. Which projects should Adamson accept?Explanation / Answer
WACC and OPTIMAL Capital Budget:
(a)
Cost of Debt = Interest Rate of New Debt Issue = r(d) = 10%
Preferred Stock Dividend = $ 5 and Preferred Stock Price = $ 50
Therefore, cost of preferred stock = Preferred Stock Dividend / Preferred Stock Price = 5 / 50 = 0.1 or 10%
Next Expected Dividend = D1 = $ 4.25 , Current Stock Price = P0 = $ 38 and growth rate = g = 5% per year
Therefore, using the market capitalization rate equation, cost of equity r(e) = [D1/P0] + g = [4.25/38] + 0.05 = .1618 OR 16.18%
(b) Weightage
of debt = 15%, preferred stock = 10% and equity = 75% (represented by w(d), w(p) and w(e) respectively)
Therefore, Adamson's WACC = (1-tax rate) x r(d) x w(d) + r(e) x w(e) + r(p) x w(p) = (1 - 0.3) x 10 x 0.15 + 16.18 x 0.75 + 10 x 0.1 = 14.185 %
(c) As projects with expected return greater than the WACC should be accepted, the projects to be accepted should be Project 1 and Project 2.
NOTE: Please raise a separate question for solution to the question in the second picture.
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