Question

Empire Electric Company (EEC) 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 25% debt and 75% common equity. Its last dividend (D0) was $2.35, its expected constant growth rate is 4%, and its common stock sells for $23. EEC's tax rate is 40%. Two projects are available: Project A has a rate of return of 13%, and Project B's return is 9%. These two projects are equally risky and about as risky as the firm's existing assets. a. What is its cost of common equity? Round your answer to two decimal places. Do not round your intermediate calculations. b. What is the WACC? Round your answer to two decimal places. Do not round your intermediate calculations. c. Which projects should Empire accept?

Answer 1

Answer:

Ke = 16.63%

WACC = 13.97%

It should reject both proejct, as they are above their average cost of capital will produce a loss.

Explanation:

We can solve for the cost of common equity using the dividend grow model

$\frac{divends_1}{return-growth} = Intrinsic \: Value$

D0 = 2.35

D1 = D0 ( 1+ g)

D1 = 2.35 x 1.04 = 2.444‬

g = 0.04

stock price = 23

$\frac{2.444}{return-0.04} = 23$

we solve for return

2.444/23 + 0.04 = 0,146260869565 = 16.63%

Now, with this rate we calculate for WACC

$WACC = K_e(\frac{E}{E+D}) + K_d(1-t)(\frac{D}{E+D})$

Ke 0.1663

Equity weight 0.75

Kd 0.1

Debt Weight 0.25

t 0.4

$WACC = 0.1663(0.75) + 0.1(1-0.4)(0.25)$

WACC 13.97250%

We multiply the equity rate by the weight of equity in the capital structure.

then we multiply the after-tax cost of debt by the debt weith on capital structure