Question

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 $1.80, its expected constant growth rate is 4%, and its common stock sells for $23. EEC's tax rate is 25%. Two projects are available: Project A has a rate of return of 11%, and Project B's return is 9%. 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. What is the WACC? Do not round intermediate calculations. Round your answer to two decimal places.

     %

3. Which projects should Empire accept? Project A or B?

Answer 1

a). According to dividend discount model, Stock price = D1/(r-g)

Where, D1 is next year expected dividend

r is cost of equity

g is constant growth rate

On putting values we have, 23 = [1.80*(1+0.04)]/r-0.04

23r - 0.92 = 1.872

r = 12.14%

b). WACC = Cost of equity*% of Equity+ Cost of Debt*% of Debt*(1-tax rate)

= 12.14%*0.55 + 9%*0.45*(1-0.25)

=9.71%

c). The project with the return higher than WACC should be accepted. Since project A's return of 11% is higher than the WACC of 9.71%, project A should be accepted.