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WACC Lancaster Engineering Inc. (LEI) has the following capital structure, which it considers to be optimal:Debt25%Preferred stock15Common equity60100%LEIs expected net income this year is $34,285.72; its established dividend payout ratio is 30%; its federal-plus-state tax rate is 40%; and investors expect future earnings and dividends to grow at a constant rate of 9%. LEI paid a dividend of $3.60 per share last year, and its stock currently sells for $54.00 per share.LEI can obtain new capital in the following ways:Preferred: New preferred stock with a dividend of $11.00 can be sold to the public at a price of $95.00 per share.Debt: Debt can be sold at an interest rate of 12%.a. Determine the cost of each capital component.b. Calculate the WACC.c. LEI has the following investment opportunities that are average-risk projects:ProjectCost at t = 0Rate of ReturnA$10,00017.4%B20,00016.0C10,00014.2D20,00013.7E10,00012.0Which projects should LEI accept? Why?
Solution:- To finance new investment opportunities Lancaster Engineering Inc. requires funds in the ratio of optimal capital structure i.e. 25% Debt, 15% Preferred stock and 60% common equity. So in order to evaluate the new investment opportunities WACC for these investment opportunities needs to be computed in the following manner. A) Determining the cost of each capital component:- Cost of debt (Kd) = Interest rate*(1-Tax rate) Kd = 12%*(1-40%) Kd = 7.20% Cost of preferred stock (Kpd) = Preferred dividend/public price of preferred stock Kpd = $11/$95 Kpd = 0.1158 i.e. 11.58% Cost of common stock (Ke) using dividend growth model will be as follows: Ke = D1/Po + G Where, D1 = Expected dividend, D1 = Do*(1+G) Do = Last year dividend Po = Current price of common stock G = Growth rate Ke = (3.6*(1+9%))/54 + 9% Ke =…

% B) Calculating WACC for the new opportunities using cost of each compnent of capital:- WACC = Ke*Wd + Kpd*Wpd + Ke*We Where, Wd = Weight of debt (25%) Wpd = Weight of preferred stock (15%) We = Weight of equity (60%) WACC = 7.2%*25% + 11.58%*15% + 16.27%*60% WACC = 13.30% C )LEI can accept all those projects whose rate of return is more than the WACC computed above i.e. 13.30%. Thus following are the projects that LEI can accept, Project Rate of Return Accepted or Rejected A 17.40% Accept B 16% Accept C 14.20% Accept D 13.70% Accept E 12% Reject

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