Problem 10-18 WACC and optimal capital budget Adams Corporation is considering f

Question

Problem 10-18
WACC and optimal capital budget

Adams Corporation is considering four average-risk projects with the following costs and rates of return:

The company estimates that it can issue debt at a rate of rd = 10%, and its tax rate is 30%. It can issue preferred stock that pays a constant dividend of $3 per year at $43 per share. Also, its common stock currently sells for $33 per share; the next expected dividend, D1, is $4.00; 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? Round your answers to two decimal places.
Cost of debt  %
Cost of preferred stock  %
Cost of retained earnings  %

What is Adams' WACC? Round your answer to two decimal places.
%

Explanation / Answer

1. Cost of Dedt(Kd) = Interest rate x (1 - t) = 10% x (1 - 0.30) = 7%

2. Cost of Preferred stock(Kp) = Dividend paid / Market price of preferred stock = 3 / 43 = 6.98%

3. Cost of Retained Earnings(Kre) = cost of Equity(Ke) = D1 / P0 + g ,where D1 = next year dividend, P0 = Current market price, g = growth
Kre = (4/33) + 0.05 = 17.12%

4.WACC = (17.12 x 75%) + (7 x 15%) + (6.98 x 10%) = 14.59%

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