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 35% debt and 65% common equity. Its last dividend (D0) was $2.65, its expected constant growth rate is 4%, and its common stock sells for $24. EEC's tax rate is 25%. Two projects are available: Project A has a rate of return of 15%, and Project B's return is 12%. These two projects are equally risky and about as risky as the firm's existing assets. What is its cost of common equity? Do not round intermediate calculations. Round your answer to two decimal places. % What is the WACC? Do not round intermediate calculations. Round your answer to two decimal places. % Which projects should Empire accept?

Answer 1

WACC=(weight of equity*cost of equity)+(weight of debt*after tax cost of debt)

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

D1=D0*(1+growth rate)=2.65*(1+4%)=2.756

Cost of common equity=(2.756/24)+4%=11.48%+4%=15.48%

2. After tax cost of debt=cost of debt*(1-tax rate)=9%*(1-25%)=6.75%

WACC=(65%*15.48%)+(35%*6.75%)=12.43%

3. Project should be selected if rate of return is greater than WACC.

Here, project A rate of return is greater than WACC where as project B is not. Therefore we should select project A