Answer:
a)
Cost of debt (after tax) = 5.4%
Cost of preferred stock ([tex]r_p[/tex]) = 10.53%
Cost of common stock ([tex]r_e[/tex]) = 16.18%
b)
WACC = 14%
c)
project 1 and project 2
Explanation:
Given that:
Debt rate ([tex]r_d[/tex]) = 9% = 0.09
Tax rate (T) = 40% = 0.4
Dividend per share ([tex]D_p[/tex]) = $6
Price per share ([tex]P_p[/tex]) = $57
Common stock price ([tex]P_0[/tex])= $39
Expected dividend ([tex]D_1[/tex]) = $4.75
Growth rate (g) = 4% = 0.04
The target capital structure consists of 75% common stock ([tex]w_e[/tex]), 15% debt ([tex]w_d[/tex]), and 10% preferred stock ([tex]w_p[/tex])
a)
Cost of debt (after tax) =`[tex]r_d(1-T)= 0.09(1-0.4)=0.09*0.6=0.054[/tex]
Cost of debt (after tax) = 5.4%
Cost of preferred stock ([tex]r_p[/tex]) = [tex]\frac{D_p}{P_P}=\frac{6}{57}=0.1053[/tex] = 10.53%
[tex]r_p[/tex] = 10.53%
Cost of common stock ([tex]r_e[/tex]) = [tex]\frac{D_1}{P_0} +g=\frac{4.75}{39} +0.04=0.1618[/tex]
[tex]r_e[/tex] = 16.18%
b)
[tex]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[/tex]
WACC = 14%
c) Only projects with expected returns that exceed WACC will be accepted. Therefore only project 1 and project 2 would be accepted
