Adamson 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 ra = 9%, and its tax rate is 35%. It can issue preferred stock that pays a constant dividend of $5 per year at $59 per share. Also, its common stock currently sells for $39 per share; the next expected dividend, D1, is $4.50; 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. The data has been collected in the Microsoft Excel Online file below. Open the spreadsheet and perform the required analysis to answer the questions below. Open spreadsheet a. What is the cost of each of the capital components? Round your answers to two decimal places. Do not round your intermediate calculations. Cost of debt % Cost of preferred stock % Cost of retained earnings % b. What is Adamson's WACC? Round your answer to two decimal places. Do not round your intermediate calculations. % c. Only projects with expected returns that exceed WACC will be accepted. Which projects should Adamson accept? Project 1 Project 2 Project 3 Project 4 B D WACC and optimal capital budget 3 Cost of debt, ra Tax rate, T Preferred dividend Preferred stock price, Pp Common stock price, Po 3 Expected common dividend, D Common stock constant growth rate, gn O % common stock in capital structure 1 % debt in capital structure 2 % preferred stock in capital structure 3 Cost of capital components 4 & WACC calculation: 5 After-tax cost of debt, ra(1-T) 6 Cost of preferred stock, rp 7 Cost of common stock, rs 9.00% 35.00% $5.00 $59.00 $39.00 $4.50 5.00% 75.00% 15.00% 10.00% Weighted Cost Weights After-tax Cost 15.00% 10.00% 75.00% WACC = 8 9 O Project acceptance analysis: Accept Project? Y/N Cost $2,000 $3,000 $5,000 $2,000 Rate of Return 16.00% 15.00% 13.75% 12.50% 1 Projects 2 1 3 2 4 3 5 4 6 7 Formulas 8 Cost of capital components & WACC calculation: After-tax cost of debt, ra(1 - T) 1 Cost of preferred stock, rp 2 Cost of common stock, rs 3 4 Weights After-tax Cost 15.00% #N/A 10.00% #N/A 75.00% #N/A WACC = Weighted Cost #N/A #N/A #N/A #N/A WACC = #N/A 3 4 5 Project acceptance analysis: 6 7 8 Projects 1 2 3 4 Rate of Return 16.00% 15.00% 13.75% 12.50% Cost $2,000 $3,000 $5,000 $2,000 AN Accept Project? Y/N #N/A #N/A #N/A #N/A 0 1 2 3 4
