Question

Empire Electric Company (EEC) uses only debt and common equity. It can borrow unlimited amounts at an interest rate of rd = 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 $2.70, its expected constant growth rate is 3%, 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 15%, and Project B's return is 8%. These two projects are equally risky and about as risky as the firm's existing assets. What is its cost of common equity? Round your answer to two decimal places. Do not round your intermediate calculations. % What is the WACC? Round your answer to two decimal places. Do not round your intermediate calculations. % Which projects should Empire accept?

Answer 1

Weight of equity = 1-D/A

Weight of equity = 1-0.5

W(E)=0.5

Weight of debt = D/A

Weight of debt = 0.5

W(D)=0.5

Cost of equity

As per DDM

Price = recent dividend* (1 + growth rate )/(cost of equity - growth rate)

22 = 2.7 * (1+0.03) / (Cost of equity - 0.03)

Cost of equity% = 15.64

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 10*(1-0.4)

= 6

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=6*0.5+15.64*0.5

WACC =10.82%

Accept project A as its return is greater than WACC