WACC and optimal capital budget Adams Corporation is considering four average-ri

Question

WACC and optimal capital budget

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

Project Cost Expected Rate of Return

1--------$2,000---16.00%

2-------- 3,000---15.00

3-------- 5,000--- 13.75

4-------- 2,000--- 12.50

The company estimates that it can issue debt at a rate of rd = 10%, and its tax rate is 40%. It can issue preferred stock that pays a constant dividend of $6 per year at $57 per share. Also, its common stock currently sells for $38 per share; the next expected dividend, D1, is $3.50; and the dividend is expected to grow at a constant rate of 7% per year. The target capital structure consists of 75% common stock, 15% debt, and 10% preferred stock.

1. 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 ________%

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

______%

Explanation / Answer

a) cost of debt: rd * (1 - tax) = 0.10 * (1 - 0.40) = 0.060, or 6.0%<after tax rate of debt (pre-tax rate is 10%)

cost of preferred stock: (valued like a perpetuity) : div/r = price, rearrange: div/price = r, 6/57 = 0.10, or 10%

use Gordon growth model and solve for r: Price at t=0: D1/(r-g), rearrange: D1/price = (r-g):
3.50/38 = 0.092<=(r-g)...0.092 - g = r, 0.092 - 0.07 = 0.022<r


b) WACC = wd(rd*(1-tx)) + wp(rp) + we(re), where w= weight, r= rate
WACC = 0.15(0.060) + 0.10(0.10) + 0.75(0.022) = 0.0355, or (round to) 3.55%

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