Question

Glencor is evaluating four average-risk projects with the following costs and rates of return: Project Cost (R) Expected Rate of Return

Project	Cost (R)	Expected Rate of Return
1	2000	16%
2	3000	15%
3	0	13,75%
4	2000	12,50%

The company estimates that it can issue debt at a rate of rd =10%, and its tax rate is 30%. It can issue preferred shares that pays a constant dividend of R5.00 per year at R49.00 per share. Also, its common shares currently sell for R36.00 per share; the next expected dividend, D1, is R3.50; and the dividend is expected to grow at a constant rate of 6% per year. The target capital structure consists of 75% common shares, 15% debt, and 10% preferred shares.
Required:
6.1 What is the cost of each of the capital components? (3)
6.2 What is Adams’s WACC? (4)
6.3 Only projects with expected returns that exceed WACC will be accepted. Which projects should Adams accept? (3)

Answer 1

6.1

Debt

Tax- rate = 30%

After tax cost of debt = k_d*(1-t) = 10%*(1-30%) = 7%

Preferred shares

Cost of preferred shares = k_p = Dividend/Market price of preferred shares =  5/49 = 10.2040816326531%

Common shares

Next year dividend = D₁ = 3.5

growth rate = g = 6%

Price of common shares = 36

Price of commom sares = D₁/(k_e - g)

therefore, k_e = (D₁/P)+g =(3.5/36)+6% = 15.722222%

6.2

D/V = 15%, P/V = 10%, E/V = 75%

where, V is the value of the firm, D= Value of Debt, P = value od preferred shares, E = value of Equity or common shares

V = D+P+E

The formula to calculate WACC is:

WACC = (7%*15%)+(10.2040816326531%*10%)+(15.722222%*75%) = 13.862074829932%

6.3

Only projects with expected returns that exceed WACC will be accepted. Hence projects 1 and 2 can only be accepted as they have an expected return of 16% and 15% respectively which is greater than WACC (13.86%)