Adams Corporation is considering four average-risk projects with the following c

Question

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


Project (1)---Cost $2,000, Expected Rate of Return--16.00%
Project (2)--Cost $3,000, Expected Rate of Return--15.00%
Project (3)---Cost--$5,000, Expected Rate of Return--13.75%
Project (4)--Cost $2,000, Expected Rate of Return--12.50%



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 $40 per share. Also, its common stock currently sells for $30 per share, the next expected dividend, D1, is $3.25, 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.

What is the cost of each of the capital components? Round your answer to two decimal places.
a. Cost of debt__________ %
b. Cost of preferred stock ___________%
c. Cost of retained earnings ______________%
d. What is Adams' WACC? Round your answer to two decimal places.
______________ %

Explanation / Answer

cost of debt is after-tax so we need to figure out that. rd = 0.10 after tax cost of debt = 0.10 x (1-0.30) = 7% (a) Some quick things about preferred stock. Its essentially similar to regular equity but the payment DOES NOT grow. Often times common equity dividends will grow but preferred stock dividends will not. That makes preferred stock similar to debt, however unlike debt, preferred stock is NOT tax deductible. Interest from debt reduces taxable income but preferred stock does not. Now that we are pass that little thing we can move on to the price of preferred stock. Recall our equation for the dividend growth model: FV = (Dividend x (1+g))/(r-g) Here g = zero (preferred dividends dont grow) and we reduce it to FV = dividend/r where r is the required return on equity. adjusting the formula we get r = dividend/FV here the price of the stock is $40 or our FV and $3 is the dividend. so our preferred cost is $3/$40 = 7.5% or the cost of preferred stock. (b) Common equity here uses the same formula as above to get the cost of retained earnings, 30 = (3.25)/(r-.04) and r is 14.8% (c) remember that 3.25 is already the next periods dividend. WACC is just the sum of each of the costs times its weight in the capital structure. WACC = (0.75 x .148) + (0.15 x 0.07) + (0.10 x 0.075) = 12.9% Finally we only accept the projects where the return is higher than the WACC. in this case we accept 1,2 and 3. Hope this help! (and is correct)

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