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 35% debt and 65% common equity. Its last dividend (Do) was $2.20, its expected constant growth rate is 6%, and its common stock sells for $26. EEC's tax rate is 40%. Two projects are available: project A has rate of return 12%, and project B/S return is 11%. These two projects are equally risky and about as risky as the firm's existing assets.
What is its cost of common equity?

Which is the WACC?

Which projects should Empire accept?

Answer 1

Answer:

cost of common equity = 14.46%

WACC = 11.29%

accept = Project A

Explanation:

Cost of common equity is the return that is required by Holders of Common Stock.

The available details can be used to calculate the cost of common equity using the Dividend Growth Model as follows :

Cost of common equity = (Next year`s Dividend / Current Market Price of a Stock) + Expected Growth

                                        = ($2.20/$26)+6%

                                        = 14.46%

WACC is the minimum return that a project must offer before it can be accepted.It shows the risk of the company.

Cost of Debt = Market Interest Rate × (1 - tax rate)

                     = 9.00% × (1-0.40)

                     = 5.40%

Capital Source                Weight                 Cost                 Total

Debt                                   35%                  5.40%               1.89%

Common Equity                65%                 14.46%               9.40%

Total                                 100%                 19.86%              11.29%

Therefore WACC is 11.29%

When evaluating projects, Compare the Project`s Internal Rate of Return (IRR) to the WACC.

Project A

IRR 12% > WACC 11.29%

Therefore Accept

Project B/S

IRR 11% < WACC 11.29%

Therefore Do Not Accept