Question

Empire Electric Company (EEC) uses only debt and common equity. It can borrow unlimited amounts at an interest rate of r_d = 11% as long as it finances at its target capital structure, which calls for 45% debt and 55% common equity. Its last dividend (D₀) was $1.70, its expected constant growth rate is 5%, and its common stock sells for $29. EEC's tax rate is 25%. Two projects are available: Project A has a rate of return of 14%, and Project B's return is 8%. 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.

   part two

   barton Industries expects that its target capital structure for raising funds in the future for its capital budget will consist of 40% debt, 5% preferred stock, and 55% common equity. Note that the firm's marginal tax rate is 25%. Assume that the firm's cost of debt, r_d, is 10.3%, the firm's cost of preferred stock, r_p, is 9.5% and the firm's cost of equity is 12.9% for old equity, r_s, and 13.2% for new equity, r_e. What is the firm's weighted average cost of capital (WACC₁) if it uses retained earnings as its source of common equity? Do not round intermediate calculations. Round your answer to two decimal places.

   %

   What is the firm’s weighted average cost of capital (WACC₂) if it has to issue new common stock? Do not round intermediate calculations. Round your answer to two decimal places.

   %

Answer 1

(1) (a) Target Capital Structure: 45% Debt and 55% Common Equity, D0 = $ 1.7, Current Stock Price = P0 = $ 29 and Growth Rate = g =5 %

Expected Dividend = D1 = D0 x (1+g) = 1.7 x 1.05 = $ 1.785

Cost of Equity = r = (D1/P0) + g = (1.785/29) + 0.05 = 0.11155 or 11.155 % ~ 11.16%

(b) Tax Rate = 25 % and Cost of Debt = rd = 11%

WACC = rd x (1-Tax Rate) x Debt Proportion + r x Equity Proportion = 11 x (1-0.25) x 0.45 + 11.16 x 0.55 = 9.845 % ~ 9.85%

(2) (a) Target Capital Structure: Debt = 40%, Preferred Stock = 5% and Common Stock = 55 %

Cost of Debt = rd = 10.3%, Cost of Preferred Stock = rp = 9.5 %, Cost of Old Equity (Retained Earnings) = rs = 12.9 % and Cost of New Equity = re = 13.2 %

Tax Rate = 25 %

WACC (if retained earnings are used) = 0.4 x (1-0.25) x 10.3 + 0.05 x 9.5 + 0.55 x 12.9 = 10.66 %

(b) If new common equity is issued and used then the cost of equity will equal the cost of issuing new common equity which is 13.2 %

WACC = 0.4 x (1-0.25) x 10.3 + 0.05 x 9.5 + 0.55 x 13.2 = 10.83 %