Adams Corporation is based on Hawaii and has four investment projects with the following costs and estimated expected rates of return (ie internal rates of return estimated from discounted cash flow analysis):
Cost
Rate of Return
Project 1
$2,200,000
16.0%
Project 2
$3,450,000
15.0%
Project 3
$5,000,000
13.75%
Project 4
$2,700,000
12.5%
Adams Corporation has a capital budget set for the coming year of $5 million (ie it intends to do project only up to this amount).
The company estimates that it can issue debt at a before-tax cost of 10% and its tax rate is 30%. The company can also issue preference shares at $45 per share, which pay a constant dividend of $4.50 per share per year.
The company's stock currently sells at $33 per share. The year-end dividend D1 is expected to be $3.20 and the dividend is expected to grow at a constant rate of5% per year. The company's capital structure consists of 75% ordinary equity, 20% debt and 5% preference shares.
Which projects should the company undertake if all projects are assumed to be of average risk? Is the capital budget an issue, and should it be?
What approaches could be used to modify the conclusion if the projects were not considered to be of similar risk?