Cream and Crimson Foods has a target capital structure of calling for 42.00 percent debt, 3.00 percent preferred stock, and 55.00 percent common equity (retained earnings plus common stock). Its before-tax cost of debt is 12.00 percent. The tax rate is 40.00%. Its cost of preferred stock is 10.76%. Its cost of common equity is 12.22%.

Suppose that Cream and Crimson has a project with an IRR of 12%. Should they ACCEPT or REJECT the project?

1 answer

To determine whether Cream and Crimson Foods should accept or reject the project, we first need to calculate the Weighted Average Cost of Capital (WACC) using the target capital structure and the provided costs for debt, preferred stock, and common equity.

  1. Calculate the after-tax cost of debt: \[ \text{After-tax cost of debt} = \text{Before-tax cost of debt} \times (1 - \text{Tax rate}) = 12.00% \times (1 - 0.40) = 12.00% \times 0.60 = 7.20% \]

  2. Determine the weights for each component of capital:

    • Weight of debt (Wd) = 42.00% = 0.42
    • Weight of preferred stock (Wp) = 3.00% = 0.03
    • Weight of common equity (We) = 55.00% = 0.55
  3. Identify the costs for each component:

    • Cost of debt (after-tax) = 7.20%
    • Cost of preferred stock = 10.76%
    • Cost of common equity = 12.22%
  4. Calculate the WACC: \[ \text{WACC} = (Wd \times \text{Cost of Debt}) + (Wp \times \text{Cost of Preferred Stock}) + (We \times \text{Cost of Common Equity}) \] \[ \text{WACC} = (0.42 \times 7.20%) + (0.03 \times 10.76%) + (0.55 \times 12.22%) \] \[ \text{WACC} = (0.42 \times 0.072) + (0.03 \times 0.1076) + (0.55 \times 0.1222) \] \[ \text{WACC} = 0.03024 + 0.003228 + 0.06721 \] \[ \text{WACC} = 0.100678 \text{ or } 10.07% \]

  5. Compare the IRR of the project with WACC: The project's Internal Rate of Return (IRR) is 12%, which is greater than the calculated WACC of 10.07%.

Since the IRR (12%) is greater than the WACC (10.07%), Cream and Crimson Foods should ACCEPT the project.