Question

WACC

Empire Electric Company (EEC) uses only debt and common equity. It can borrow unlimited amounts at an interest rate of r_d = 9% as long as it finances at its target capital structure, which calls for 45% debt and 55% common equity. Its last dividend (D₀) was $2.85, its expected constant growth rate is 5%, 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 10%. These two projects are equally risky and about as risky as the firm's existing assets.

1. What is its cost of common equity? Round your answer to two decimal places. Do not round your intermediate calculations.
   %
2. 
   
3. What is the WACC? Round your answer to two decimal places. Do not round your intermediate calculations.
   %
4. 
   
5. Which projects should Empire accept?

Answer 1

a)	Cost of common equity using Constant dividend growth formula = D1/P0+g.
	Where, D1 = next expected dividend, g=growth
	rate and P0 = current price.
	= 2.85*1.05/30+0.05 =	14.98%
b)	After tax cost of debt = 9%*(1-40%) =	5.40%
c)	WACC = 14.98%*55%+5.40%*45% =	10.67%
d)	As the two available projects are equally risky
	as the firm's existing assets, the WACC would
	be the cost of capital for those projects.
e)	Under the IRR rule, all projects with IRR>COC
	are to be accepted as their NPV would be
	positive.
	Hence, Project A with 14% IRR should be accepted
	and Project B with 10% IRR should be rejected.