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:

The company estimates that it can issue debt at a rate of rd = 9%, and its tax rate is 40%. It can issue preferred stock that pays a constant dividend of $4 per year at $40 per share. Also, its common stock currently sells for $30 per share; the next expected dividend, D1, is $3.75; 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.

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

Explanation / Answer

rd = 0.09

after tax cost of debt = 0.09 x (1-0.40) = 5.4% (a)

preferred cost is $4/$40 = 10% or the cost of preferred stock. (b)

cost of retained earnings

30 = 3.75/(r - 0.04)

cost of retained earnings = 16.5%

WACC = (0.75 x .165) + (0.15 x 0.054) + (0.10 x 0.1) = 14.185%

Aceept projects ! and 2 as their expected returns acced WACC

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