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 35% debt and 65% common equity. Its last dividend (D₀) was $2.15, its expected constant growth rate is 4%, and its common stock sells for $21. 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 11%. 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. 
   
3. What is the WACC? Do not round intermediate calculations. Round your answer to two decimal places.
     %
4. 
   
5. Which projects should Empire accept?
   

Answer 1

Calculate the cost equity as follows:

Cost of equity = (Expected dividend / Price) + Growth rate

Cost of equity = ((2.15*(1+4%))/ 21) + 4%

Cost of equity =14.647619%

Therefore, cost of common equity is 14.65%.

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Calculate the after tax cost of debt as follows:

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

After tax cost of debt = 10% * (1-40%)

After tax cost of debt = 6%

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Calculate the WACC as follows:

WACC = (Weigh of equity * Cost of equity) + (Weight of debt * after tax cost of debt)

WACC = (65%*14.647619%) + (35% * 6%)

WACC = 11.62%

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As the company WACC is 11.62% and return from project A is 13% and return from the project B is 11%.

Project A return is greater than WACC.

So, accept project A.