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 30% debt and 70% common equity. Its last dividend (D0) was $1.50, its expected constant growth rate is 5%, and its common stock sells for $25. 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.

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.
%

Answer 1

By definition, dividend discount model (DDM) is a system for valuing the price of a stock by using predicted dividends and discounting them back to present value.

Now, the discount rate, K_e is basically the required rate of return or cost of equity.

Dividend for next year = Dividend for last year * (1 + 5%)

=> Dividend for next year = $1.50 * (1 + 5%)

=> Dividend for next year = $1.575

Hence, by plugging in values in the formula,

=> K - 0.05 = 0.063

=> K = 11.30%. This is the Cost of Equity

WACC is weighted average cost of capital, where weight is the proportion of the component in overall capital. Mathematically,

WACC = Weight of Debt * Cost of Debt * (1 - tax rate) + Weight of equity * Cost of Equity

=> WACC = (30% * 9% * (1 - 40%)) + (70% * 11.30%)

=> WACC = 1.62% + 7.91%

=> WACC = 9.53%