2. A firm has four investment projects with the following costs and rates of ret
ID: 2618811 • Letter: 2
Question
2. A firm has four investment projects with the following costs and rates of return: Cost Rate of Return Project 1 Project 2 Project 3 Project 4 $2,000 3,000 5,000 2,000 16.00% 15.00% 13.75% 12.50% The company estimates that it can issue debt at a before-tax cost of 10 percent, and the tax rate is 30 percent. The company also can issue preferred stock at $49 per share which pays a constant dividend of $5 per year The constant dividend growth model is used to find the cost of equity. The company's stock currently sells at $36 per share. The year-end dividend, D, is expected to be $3.50, and the dividend is expected to grow at a constant rate of 6 percent per year. The company's capital structure consists of 75 percent common stock, 15 percent debt, and 10 percent preferred stock. a. What is the cost of each of the capital components? b. What is the WACC? c. Which projects should the firm select if the projects are all of average risk? Explain.Explanation / Answer
(a) Calculation of cost of capital components
(i) Calculation of cost of debt
Interest on debt = 10%
Tax rate = 30%
Kd = I(1 - T)
where,
Kd = Cost of debt after tax
I = Interest rate
T = Tax rate
Kd = 10 (1 - 0.30)
= 10 x 0.7
= 7%
(ii) Calculation of cost of preferred stock
Issue price of preferred stock = $49
Dividend payable on preferred stock = $5
Kp = PD/NP
where,
Kp = Cost of preferred stock
PD = Dividend on preferred stock
NP = Net proceeds (Issue price)
Kp = 5/49
= 10.20%
(iii) Calculation of cost of equity
Current market price of 1 equity share (P0) = $36
Year end dividend (D1) = $3.50
Expected growth rate in dividend (g) = 6%
Ke = (D1/P0) + g
where,
Ke = Cost of equity
Ke = (3.5/36) + 0.06
= 0.0972 + 0.06
= 0.1572
= 15.72%
(b) Calculation of WACC
Hence, WACC = 13.86%
(c) The company should select all those projects whose rate of return is more than WACC of the company. Hence project 1 and project 2 should be selected because their rate of return is more than WACC of the company. On the other hand, project 3 and project 4 should not be selected since their rate of return is less than WACC of the company
Source Specific cost Weight Specific cost x Weight Common stock 15.72% 0.75 15.72 x 0.75 = 11.79% Debt 7% 0.15 7 x 0.15 = 1.05% Preferred stock 10.20% 0.10 10.20 x 0.10 = 1.02% WACC 11.79 + 1.05 + 1.02 = 13.86%Related Questions
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