Project Cost Expected return A $3.5 million 11.2% B $2.5 million 10.5% C $4.1 mi

Question

Project Cost Expected return

A $3.5 million 11.2%

B $2.5 million 10.5%

C $4.1 million 8.6%

XYZ Ltd. is considering three average risk projects above. The company estimates that it can issue debt at a rate of rd = 9.5% and its tax rate is 25%. It can issue preferred stock that pays a constant dividend of $2 per year at $26 per share. Its common stock currently sells for $22 per share with the next expected dividend is $1.20 and the dividend is expected to grow at a constant rate of 6% per year. The target capital structure consists of 50% common stock, 35% debt and 15% preferred stock.

i) What is its cost of debt, preferred and common stock? What is its WACC?

ii) Which project should be accepted? Only projects with expected returns that exceed WACC will be accepted.

Explanation / Answer

The cost of each of the capital components:

Cost of debt = rd(1 - T) = 0.095(1 - 0.25) = 7.13%

Cost of preferred stock

rp = $2/$26 => 7.69%

Cost of common stock(rs)

(1.20/22) + 6% = 11.45%

WACC = wdrd(l - T) + wprp + wsrs

WACC = 0.35(0.0713) + (0.15)(0.0769) + (0.50)(0.1145)

WACC = 9.37%

Project A and B will be accepted because their rates of return exceed the WACC.

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