Question

Empire Electric Company (EEC) uses only debt and common equity. It can borrow unlimited amounts at an interest rate of rd = 9% as long as it finances at its target capital structure, which calls for 50% debt and 50% common equity. Its last dividend (D0) was $3.25, 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 13%, and Project B's return is 8%. These two projects are equally risky and about as risky as the firm's existing assets.

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

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

C) Should Empire accept Project A or Project B?

  

Answer 1

Answer a)

Value of Stock =

22 =

22 * Rate of Return - 0.04* 22 = 3.38

22 * Rate of Return - 0.88 = 3.38

Rate of Return = 3.38 +0.88 / 22

19.36%

Answer b)

WACC = (Cost of Equity * Weight of Equity) + (Cost of Debt after tax * Weight of Debt)

= 19.36% * 0.50 + 9% (1-0.40) * 50%

= 12.38%

Answer b)

Project A should be acceped as the Return is more than the WACC while Project B should be rejected.

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