Question

Empire Electric Company (EEC) uses only debt and common equity. It can borrow unlimited amounts at an interest rate of r_d = 10% as long as it finances at its target capital structure, which calls for 50% debt and 50% common equity. Its last dividend (D₀) was $2.55, its expected constant growth rate is 4%, and its common stock sells for $22. EEC's tax rate is 40%. Two projects are available: Project A has a rate of return of 11%, and Project B's return is 12%. These two projects are equally risky and about as risky as the firm's existing assets.

1. What is its cost of common equity? Round your answer to two decimal places. Do not round your intermediate calculations.
   %
2. 
   
3. What is the WACC? Round your answer to two decimal places. Do not round your intermediate calculations.
   %
4. 
   
5. Which projects should Empire accept?
   -Select-Project AProject B

Answer 1

Question a:

Last Dividend = D0 = $2.55

Growth rate = g = 4%

Next Dividend = D1 = D0*(1+g) = $2.55 * (1+4%) = $2.652

Current Share Price = P0 = $22

Cost of Common Equity = (D1/P0) + g

= ($2.652 / $22) + 4%

= 0.120545454 + 0.04

= 0.160545454

= 16.05%

Question b:

re = cost of common equity = 16.05%

rd = cost of debt = 10%

Wd = Weight of debt = 50%

We = Weight of Equity = 50%

t = tax rate = 40%

WACC = [Wd * rd* (1-t)] + [We * re]

= [50% * 10% * (1-40%)] + [50% * 16.05%]

= 3% + 8.025%

= 11.025%

Therefore, WACC is 11.03%

Question c:

Project A's rate of Return = 11%

Project B's rate of Return = 12%

WACC (11.03%) > Project A's Rate of Return (11%) - Project A should be rejected

WACC (11.03%) < Project A's Rate of Return (12%) - Project B should be accepted