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 40% debt and 60% common equity. Its last dividend (D₀) was $2.50, its expected constant growth rate is 5%, and its common stock sells for $21. EEC's tax rate is 25%. Two projects are available: Project A has a rate of return of 15%, 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?

   Project A

Answer 1

Rate of debt = 10%

Dividend (D0) = $ 2.5

Div growth = 5%

Debt = 40%

Equity = 60%

Share price = $ 21

Corporate tax = 25%

Project A : E(Ra) = 15%

Project B : E(Rb) = 9%

a. Using Dividend growth model :

Cost of common equity = (Div1/share price) + growth = (2.5(1 + 5%) / 21 ) + 5% = 17.5%

b. Weighted average cost of capital (WACC) :

WACC = (E/(E+D))*Re + (D/(E+D))*Rd*(1-corp tax) = 0.6(17.5%) + 0.4(10%)(0.75) = 0.135 = 13.5%

c. Empire should accept project A as the two projects are equally risky with A giving more returns than B.