Question

Problem 10-18 WACC and optimal capital budget Adamson Corporation is considering four average-risk projects with the following costs and rates of return: Project Cost Expected Rate of Return $2,000 16.00% 3,000 15.00 5,000 13.75 2,000 12.50 The company estimates that it can issue debt at a rate of ra = 9%, and its tax rate is 30%. It can issue preferred stock that pays a constant dividend of $6 per year at $40 per share. Also, its common stock currently sells for $33 per share; the next expected dividend, D1, is $3.75; 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? Round your answers to two decimal places. Do not round your intermediate calculations. Cost of debt % Cost of preferred stock Cost of retained earnings b. What is Adamson's WACC? Round your answer to two decimal places. Do not round your intermediate calculations. % c. Only projects with expected returns that exceed WACC will be accepted. Which projects should Adamson accept? Project 1 ✓ -Select- accept reject Project 2 Project 3 -Select- : Project 4 -Select-

Answer 1

rate positively ..

Ans a)
	Cost of debt =		cost of debt *(1-tax rate)
			9%*(1-30%)
			6.30%
	Cost of preferred stock =		Annual dividend/Price of preferred stock
			6/40
			15.00%
	Cost of retained earning =		Expected dividend next year/price today + growth rate
			3.75/33+5%
			16.36%
Ans b)	WACC computation
	Source	Weight	Cost of capital	Weight * cost
	Debt	15%	6.30%	0.95%
	preferred stock	10%	15.00%	1.50%
	Equity	75%	16.36%	12.27%
				14.72%
Ans c)
	Project 1	ACCEPT
	Project 2	ACCEPT
	Project 3	REJECT
	Project 4	REJECT