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 rd = 10%, and its tax rate is 25%. It can issue preferred stock that pays a constant dividend of $5.00 per year at $59.00 per share. Also, its common stock currently sells for $46.00 per share; the next expected dividend, D1, is $5.25; 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. What is the cost of each of the capital components? Do not round intermediate calculations. Round your answers to two decimal places. Cost of debt:   % Cost of preferred stock:   % Cost of retained earnings:   % What is Adamson's WACC? Do not round intermediate calculations. Round your answer to two decimal places.   % Only projects with expected returns that exceed WACC will be accepted. Which projects should Adamson accept? Project 1 -Select-Accept Reject Project 2 -Select-Accept Reject Project 3 -Select-Accept Reject Project 4 -Select-Accept Reject

Answer 1

A)Cost of debt

After tax cost of debt =interest*(1-tax rate)

Tax rate =25% Interest rate =10% After tax cost of debt =.1*(1-.25)=.1*.75==.075 that is 7.5%

b)Cost of preferred stock =Dividend /price

Dividend =$5.00 Price =$59.00 Cost of preferred stock =$5/59=.0847 that is 8.47%

c)Cost of equity

Cost of equity =(D subscript 1(expected Dividend )/P subscript 0(Current Price))+g(growth rate)

Cost of equity =$5.25 Current price =$46.00 g=5% Cost of equity =(5.25/46)+.05=.1641 that is 16.41%

b)WACC Weighted Average Cost of capital =Cost of equity *% of equity +Cost of debt*%of debt *(1-tax rate)+Cost of Preferred stock *%of preferred stock

Cost of equity =16.41% % of equity =75% Cost of debt =7.5% % of debt= 15% cost of preferred stock =8.47% % of preferred stock =10%

WACC =0.1641%*0.75+0.075*0.15+.0847*.10 =.123+.01125+.00847=.14272 =14.272%

3)Only project 1( 16.00%) and project 2(15.00%) are accepted since their expected returns are higher than WACC

Project 3(13.75%) and project 4(12.50%) are rejected since their expected returns are lower than WACC.

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