Question

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 r_d= 10%, and its tax rate is 30%. It can issue preferred stock that pays a constant dividend of $6 per year at $58 per share. Also, its common stock currently sells for $32 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. The data has been collected in the Microsoft Excel Online file below. Open the spreadsheet and perform the required analysis to answer the questions below.

Open spreadsheet

WACC and optimal capital budget
Cost of debt, rd	10.00%
Tax rate, T	30.00%
Preferred dividend	$6.00
Preferred stock price, Pp	$58.00
Common stock price, P0	$32.00
Expected common dividend, D1	$3.25
Common stock constant growth rate, gn	6.00%
% common stock in capital structure	75.00%
% debt in capital structure	15.00%
% preferred stock in capital structure	10.00%
"Cost of capital components & WACC calculation:"	Weights	After-tax Cost	Weighted Cost
After-tax cost of debt, rd(1 – T)	15.00%
Cost of preferred stock, rp	10.00%
Cost of common stock, rs	75.00%
		WACC =
Project acceptance analysis:
Projects	Cost	Expected Rate of Return	Accept Project? Y/N
1	$2,000	16.00%
2	$3,000	15.00%
3	$5,000	13.75%
4	$2,000	12.50%
Formulas
"Cost of capital components & WACC calculation:"	Weights	After-tax Cost	Weighted Cost
After-tax cost of debt, rd(1 – T)	15.00%	#N/A	#N/A
Cost of preferred stock, rp	10.00%	#N/A	#N/A
Cost of common stock, rs	75.00%	#N/A	#N/A
		WACC =	#N/A
Project acceptance analysis:
Projects	Cost	Expected Rate of Return	Accept Project? Y/N
1	$2,000	16.00%	#N/A
2	$3,000	15.00%	#N/A
3	$5,000	13.75%	#N/A
4	$2,000	12.50%	#N/A

1. 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 %

2. What is Adamson's WACC? Round your answer to two decimal places. Do not round your intermediate calculations.

   %

3. Only projects with expected returns that exceed WACC will be accepted. Which projects should Adamson accept?

   Project 1

Project 2

Project 3

Project 4

Answer 1

We know that:

Cost of debt, rd

10.00%

A.

Cost of Debt = Interest *(1-Tax rate)

Tax rate, T

30.00%

Cost of Debt = 10% *(1-30%)

Preferred dividend

$6.00

Cost of Debt = 7%

Preferred stock price, Pp

$58.00

% of weight in capital = 15%

Common stock price, P0

$32.00

Expected common dividend, D1

$3.25

Cost of preferred stock = Preferred stock dividend/preferred stock price

Common stock constant growth rate, gn

6.00%

Cost of preferred stock = 6/58

% common stock in capital structure

75.00%

Cost of preferred stock = 10.34%

% debt in capital structure

15.00%

% of weight in capital = 10%

% preferred stock in capital structure

10.00%

Cost of common stock = (common stock dividend/common stock price)+Growth rate

Cost of preferred stock = (3.25/32)+0.06

Cost of preferred stock = 16.16%

% of weight in capital = 75%

B.

WACC = (Cost of debt*% of weight in capital)+(cost of preferred stock*% of weight in capital)+(cost of retained earnings*% of weight in cost)

WACC = (0.07*0.15)+(0.1034*0.10)+(0.1616*0.75)

WACC = 0.14204 or 14.20%

C.

As calculated, WACC of Adamson's is 14.20%, so the projectes with returns giving WACC or exceeding WACC will only be accepted.

So, therefore based on the above, only Project 1 and Project will be accepted as they give returns with or exceeding WACC