Question

Empire Electric Company (EEC) uses only debt and common equity. It can borrow unlimited amounts at an interest rate of r_d = 9% as long as it finances at its target capital structure, which calls for 45% debt and 55% common equity. Its last dividend (D₀) was $2.75, its expected constant growth rate is 6%, and its common stock sells for $30. EEC's tax rate is 40%. Two projects are available: Project A has a rate of return of 12%, and Project B's return is 11%. These two projects are equally risky and about as risky as the firm's existing assets.

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

Answer 1

1. Formula to calculate the current share price by dividend discount model with constant dividend growth rate

Current Stock Price P0 = D1 / (r – g)

Where:

P0 = the current stock price = $30

Last dividend paid D0 = $2.75 per share

g = growth rate of dividends = 6% per year

Dividend for next year D1 = D0 * (1+ dividend growth rate) = $2.75 * (1+6%) = $2.915

r = required rate of return or cost of equity =?

Therefore

$30 = $2.915 / (r - 6%)

Or $30 *(r - 6%) = $2.915

Or $30 r - $30 *6% = $2.915

Or $30 r - $1.80 = $2.915

Or $30 r = $2.915 + $1.80 = $4.715

Or r =$4.715 /$30 = 0.1572 or 15.72%

Therefore the company’s cost of common equity is 15.72%

2. The weighted cost of capital (WACC)

WACC = wd *rd (1 - t) + we*re                 

Where,

we is the weight of equity = 55% or 0.55

wd is value of debt = 45% or 0.45

rd is the before-tax cost of debt = 9%

t is the company’s tax rate = 40%

re is the cost of equity = 15.72%

Therefore,

WACC = 0.45 * 9% * (1-40%) + 0.55 * 15.72%

= 2.43% + 8.64%

= 11.07%

The weighted cost of capital (WACC) is 11.07%

Project A has a rate of return of 12%; it is accepted as rate of return is more than WACC.

And Project B's return is 11%; it is not accepted as WACC is more than its rate of return.