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 30% debt and 70% common equity. Its last dividend (D₀) was $2.05, its expected constant growth rate is 4%, and its common stock sells for $23. 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 9%. 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).

Last Dividend (D0) = $2.05

Constant Growth rate(g) = 4%

Current Price of Stock(P0) = $23

Calculating the cost of equity using Dividend Growth model:-

Ke = 13.27%

So, Cost of common equity is 13.27%

2).

Before tax cost of debt = 10%

Target Capital structure consists of 30% debt and 70% equity

Calculating WACC:-

WACC= (Weight of Debt)(before-tax Cost of Debt)(1-Tax Rate) + (Weight of Equity)(Cost of Equity)

WACC = (0.30)(10%)(1-0.25) + (0.70)(13.27%)

WACC = 2.25% + 9.289%

WACC = 11.54%

So, WACC is 11.54%

3). Project A has a rate of return of 14%, and Project B's return is 9%. As these projects are equally risky and about as risky as the firm's existing assets. Thus, the Project which will provide higher/greater rate of return than the Target WACC of the capital syructure will be chosen.

Since, project A's rate of return is less than the WACC while project B's rate of return is higher than WACC.

Hence, Project A should be accepted.

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