Adams Corporation is evaluating the cost of capital for one of its projects with

Question

Adams Corporation is evaluating the cost of capital for one of its projects with average risK. he company estimates that it can issue debt at 10 percent (yield-to-maturity), and its tax rate is 30 percent. The expected dividend (D.) is $3.50, and the dividend is expected to grow at a constant rate of 6 percent per year for the foresecable future. Adams Corporation stock is currently selling at $35.00/share. The target capital ratio consists of 60 percent common stock and 40 percent debt. 110) What is the after-tax cost of debt capital? (5pts) Show your work below (A) 5% (B) 6% (C) 7% (D) 9% (E) 1196 11 (ii) What is the cost of equity capital? (5pts) Show your work below (A) 10% (B) 12% (C) 14% (D) 16% (E) 18% 11 (ii) What is the Adam's cost of capital (WACC) (5 pts) Show your work below (A) 10.5% (B) 12.4% (C) 14.5% (D) 11.4% (E) 16.5%

Explanation / Answer

a.

Pre tax Cost of debt = Yield to maturity

After tax cost of debt = YTM*(1-Tax) = 10%*(1-0.3) = 7%

b.

According to dividend-discount model,

P0 = D1/(R-G)

P0 = Current stock price

D1 - Dividend at t =1

R - Cost of equtiy

G - Growth rate

35 = 3.5/(R-6%)

R = 0.16 = 16%

c.

WACC = rD (1- Tc )*( D / V )+ rE *( E / V )

Where...

rD = The required return of the firm's Debt financing
(1-Tc) = The Tax adjustment for interest expense
(D/V) = (Debt/Total Value)
rE= the firm's cost of equity
(E/V) = (Equity/Total Value)

WACC = 0.4*7%+0.6*16% = 0.1240% = 12.40%

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