Question

WACC AND PERCENTAGE OF DEBT FINANCING  Hook industries’ capital structure consist of 55% common equity and 45% debt, and its tax rate is 40%. Olsen must raise additional capital cost of r_d = 11%, and its common stock currently pays a $2.00 dividend per share (D₀ = $2.00). The stock’s price is currently $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 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?

2. What is the WACC?

3. Which projects should Empire accept?

Answer 1

1)

Dividend in year 1 = 2 (1 + 6%) = 2.12

Cost of common equity = (Year 1 dividend / price) + growth rate

Cost of common equity = (2.12 / 26) + 0.06

Cost of common equity = 0.08154 + 0.06

Cost of common equity = 0.1415 or 14.15%

2)

WACC = Weights * costs

WACC = 0.55*0.1415 + 0.45*0.11*(1 - 0.4)

WACC = 0.07783 + 0.0297

WACC = 0.1075 or 10.75%

3)

Project A should be accepted as the rate of return is greater than WACC of 11%.