Question

IDTAP WACC and optimal capital budget Q Search the Adamson Corporation is considering four average-risk projects with the following costs and rates of return: Project Expected Rate of Return 16.00% Cost $2,000 3,000 5,000 2,000 15.00 13.75 12.50 The company estimates that it can issue debt at a rate of -10%, and its tax rate is 30%. It can issue preferred stock that pays a constant dividend of $4 per year at $51 per share. Also, its common stock currently sells for $33 per share; the next expected dividend, D. is $4.00; and the dividend is expected to grow at a constant rate of 4% 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. Back 2:20 AM 3/30/2020

Answer 1

Qa) Cost of debt = rate of return ( 1- tax rate)

= 10% ( 1- 0.30)

= 10% (0.70)

= 7%

Cost of preferred stock= dividend / price

= 4 / 51

= 7.84%

Cost of equity = D1/ price + growth rate

= 4 / 33 + 0.04

= 0.1212 + 0.04

= 16.12%

B) WACC = weight of debt × cost of debt + weight of preferred stock × cost of preferred stock + weight of equity × cost of equity

= 0.15 × 7% + 0.10 × 7.84% + 0.75 × 16.12%

= 1.05% + 0.784% + 12.09%

= 13.924%

Project 1 and Project 2 are accepted, as they have higher return than WACC.

The same formulas should be used in excel as given.