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 35% debt and 65% common equity. Its last dividend (D0) was $3.30, its expected constant growth rate is 6%, and its common stock sells for $30. EEC's tax rate is 40%. 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.

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

1)

Cost of common equity = (D1 / share price) + growth rate

Cost of common equity = [(3.3 * 1.06) / 30] + 0.06

Cost of common equity = 0.1166 + 0.06

Cost of common equity = 0.1766 or 17.66%

2)

WACC = Weight of debt*after tax cost of debt + weight of equity*cost of equity

WACC = 0.35*0.1*(1 - 0.4) + 0.65*0.1766

WACC = 0.021 + 0.11479

WACC = 0.1358 or 13.58%

Project A should be accepted as the rate of return is more than WACC

Project B should be rejected as the rate of return is less than WACC