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 45% debt and 55% common equity. Its last dividend (D₀) was $1.50, its expected constant growth rate is 5%, and its common stock sells for $22. EEC's tax rate is 25%. Two projects are available: Project A has a rate of return of 14%, and Project B's return is 9%. These two projects are equally risky and about as risky as the firm's existing assets.

1. What is its cost of common equity? Do not round intermediate calculations. Round your answer to two decimal places.

     %

2. What is the WACC? Do not round intermediate calculations. Round your answer to two decimal places.

     %

3. Which projects should Empire accept?

   Project A or Project B?

Answer 1

i) Cost of equity=(D1/Common stock price)+growth rate

D1=D0*(1+g)=$1.50*(1+5%)=1.575

Cost of equity=(1.575/22)+5%=7.16%+5%=12.16%

ii) After tax cost of debt=cost of debt*(1-tax rate)=10%*(1-25%)=7.5%

Weight of debt=45%

Weight of common equity=55%

WACC=(weight of debt*after tax cost of debt)+(weight of common equity*cost of equity)=(45%*7.5%)+(55%*12.16%)=10.06%

iii) To accept the project, the rate of return should be greater than WACC.

Project A rate of return is 14% > 10.06%

Proejct B rate of return is 9% < 10.06%

Hence, Project A should be accepted