Question

Empire Electric Company (EEC) uses only debt and common equity. It can borrow unlimited amounts at an interest rate of r_d = 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 $1.90, its expected constant growth rate is 4%, and its common stock sells for $30. EEC's tax rate is 25%. Two projects are available: Project A has a rate of return of 10%, 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.

   %

3. Which projects should Empire accept?

   -Select-Project AProject B

Answer 1

1. What is its cost of common equity? Do not round intermediate calculations. Round your answer to two decimal places.

Dividend = $ 1.90; Stock Price = $ 30.00; Constant Growth = 4%; Assume = Cost of Equity = x%

Stock Price = Dividend / (Cost of Equity% - Growth%)

=> Cost of Equity% = (Dividend/Stock Price) + Growth%

=> (1.90 / 30) + 4% = 6.33% + 4% = 10.33%

Cost of Common equity = 10.33%

2. What is the WACC? Do not round intermediate calculations. Round your answer to two decimal places.

Cost of Debt = 10%; Tax rate = 25%; Hence Post Tax Cost of Debt = 10% * (1-25%) = 7.50%

Cost of Common Equity = 10.33%; Debt Equity weightage = 45% Debt and 55% Common Equity

WACC = Post Tax cost of debt * Debt weightage + cost of common equity * equity weightage

=> (7.50% * 45%) + (10.33% * 55%) = 3.38% + 5.68% = 9.06%

WACC is 9.06%

3. Which projects should Empire accept?

Project A is 10% and Project B is 8%;

Answer: Since Project A is delivering the return higher than WACC of 9.06%, Empire should accept Project A.