Question

Midwest Electric Company (MEC) uses only debt and common equity. It can borrow unlimited amounts at an interest rate of rd= 10% 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, its expected constant growth rate is 4%, and its common stock sells for $20. MEC’s tax rate is 40%. Two projects are available: Project A has a rate of return of 13% while Project B’s return is 10%. These two projects are equally risky and about as risky as the firm’s existing assets.a.
a. What is the cost of common equity?
b. What is the WACC?
c. What projects should Miswest accept?

Answer 1

Answer:

a.cost of common equity is 14.40%

b.WACC is 10.62%

c.Midwest Electric Company should accept project A since it has a rate of return higher than WACC of 10.62%

Explanation:

The cost of common equity can be ascertained using the stock price formula and changing the subject of the formula to r(cost of common equity)

Stock price=Do*(1+g)/(r-g)

stock price is $20

g is the dividend growth rate at 4%

Do is the dividend just paid $2

20=2*(1+4%)/(r-4%)

20=2.08/r-4%

20(r-4%)=2.08

r-4%=2.08/20

r=(2.08/20)+4%

r=14.40%

WACC=Ke*E/V+Kd*D/V*(1-t)

Ke is the cost of equity of 14.40%

E is the 55% or 0.55

D is 45% or 0.45

V=E+D=045+0.55=1

Kd is the cost of debt which is 10%

t is the tax rate at 40% or 0.40

WACC=14.40%*0.55/1+10%*0.45/1*(1-0.4)

WACC=(14.40%*0.55/1)+(10%*0.45/1*0.6)

WACC=10.62%

Midwest Electric Company should accept project A since it has a rate of return higher than WACC of 10.62%