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WACC AND OPTIMAL CAPITAL BUDGET Adams Corporation is considering four averagerisk projects with the following costs and rates of return:ProjectCostExpected Rate of Return1$2,00016.00%23,00015.0035,00013.7542,00012.50The 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 $5.00 per year at $49.00 per share. Also, its common stock currently sells for $36.00 per share; the next expected dividend, D1, is $3.50; and the dividend is expected to grow at a constant rate of 6% per year. The target capital structure consists of 75% common stock, 15% debt, and 10% preferred stock.a. What is the cost of each of the capital components?b. What is Adams WACC?c. Only projects with expected returns that exceed WACC will be accepted. Which projects should Adams accept?
Solution Given Cost of debt, rd= 10% Tax rate = 30% Preferred stock Dividend – $5 Preferred stock Issue price – $49 Current price of Equity – $36 Dividend for next year (D1)- $3.5 % growth in dividend, g 6% Target capital structure: Common stock (equity) = 75% Debt = 15% Preferred stock = 10% Workings Cost of debt (post-tax) = 10%*(1-30%) = 7% Cost of preferred stock = Preferred stock dividend / Preferred stock issue price = 5/49 = 10.20% (rounded off) Cost of equity computation: Current market price = D1/(1+Ke)^1+D1*(1+g)/(Ke-g) 36 = [3.5/(1+Ke)^1] + [3.5*(1+6%)/(Ke-6%)/(1+Ke)^1] Solving for the equation, we will get Ke = 15.72% 1. Cost of each of the capital components Cost of…

equity 15.72% Cost of debt 7% Cost of preferred stock 10.20% 2. WACC (Cost of equity*Equity%)+(Cost of debt*Debt%)+(Cost of preferred stock*Preferred stock%) = (15.72%*75%)+(7%*15%)+(10.20%*10%) = 13.862% 3. Projects to be accepted Based on the WACC of 13.862%, only those projects whose expected return is greater than 13.862% should be accepted, which are Project 1 (expected return of 16%) and Project 2 (expected return of 15%).


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