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 50% debt and 50% common equity. Its last dividend (D0) was $2.85, its expected constant growth rate is 3%, 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 10%, 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? 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

Answer a.

Last Dividend, D0 = $2.85
Growth Rate, g = 3%
Current Price, P0 = $21.00

D1 = D0 * (1 + g)
D1 = $2.85 * 1.03
D1 = $2.9355

Cost of Common Equity = D1 / P0 + g
Cost of Common Equity = $2.9355 / $21.00 + 0.03
Cost of Common Equity = 0.1398 + 0.03
Cost of Common Equity = 0.1698 or 16.98%

Answer b.

Weight of Debt = 50%
Pretax Cost of Debt = 9%
Weight of Equity = 50%
Cost of Common Equity = 16.98%

WACC = Weight of Debt * Pretax Cost of Debt * (1 - tax) + Weight of Equity * Cost of Common Equity
WACC = 50% * 9.00% * (1 - 0.40) + 50% * 16.98%
WACC = 11.19%

Answer c.

EEC should select the project whose rate of return is higher than the WACC.

Rate of return of Project B is higher than the WACC. So, Empire should select Project B.