Question

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 $6 per year at $57 per share. Also, its common stock currently sells for $39 per share; the next expected dividend, D1, is $4.75; 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. 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 % What is Adamson's WACC? Round your answer to two decimal places. Do not round your intermediate calculations. % Only projects with expected returns that exceed WACC will be accepted. Which projects should Adamson accept? Project 1 Project 2 Project 3 Project 4

Answer 1

a)

Cost of debt (after tax) = 5.4%

Cost of preferred stock (
`r_p`) = 10.53%

Cost of common stock (
`r_e`) = 16.18%

b)

WACC = 14%

c)

project 1 and project 2

Step-by-step explanation:

Given that:

Debt rate (
`r_d`) = 9% = 0.09

Tax rate (T) = 40% = 0.4

Dividend per share (
`D_p`) = $6

Price per share (
`P_p`) = $57

Common stock price (
`P_0`)= $39

Expected dividend (
`D_1`) = $4.75

Growth rate (g) = 4% = 0.04

The target capital structure consists of 75% common stock (
`w_e`), 15% debt (
`w_d`), and 10% preferred stock (
`w_p`)

a)

Cost of debt (after tax) =`
`r_d(1-T)= 0.09(1-0.4)=0.09*0.6=0.054`

Cost of debt (after tax) = 5.4%

Cost of preferred stock (
`r_p`) =
`(D_p)/(P_P)=(6)/(57)=0.1053` = 10.53%

`r_p` = 10.53%

Cost of common stock (
`r_e`) =
`(D_1)/(P_0) +g=(4.75)/(39) +0.04=0.1618`

`r_e` = 16.18%

b)

`WACC=w_dr_d(1-T)+w_er_e+w_pr_p\\WACC=0.15*0.09(1-0.4)+0.75*0.1618+0.1*0.1053=0.14`

WACC = 14%

c) Only projects with expected returns that exceed WACC will be accepted. Therefore only project 1 and project 2 would be accepted