Question

Empire Electric Company (EEC) uses only debt and common equity. It can borrow unlimited amounts at an interest rate of rd = 11% as long as it finances at its target capital structure, which calls for 30% debt and 70% common equity. Its last dividend (D0) was $1.85, 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 12%, and Project B's return is 9%. These two projects are equally risky and about as risky as the firm's existing assets.

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

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

Which projects should Empire accept?

Answer 1

Cost of common equity= (Dividend of next year/ Price per share) + growth rate

= ((1.85(1.04)) / 30 ) + 0.04= 10.41% (approx)

Cost of debt= Interest rate (1-tax)= 11(1-0.25)= 8.25% (assuming the interest rate given is pre tax)

Cost of capital (WACC)= weighted average of the costs of raising various sources of finance (taking the target

capital structure as weights)

= (Ke*0.7) + (Kd*0.3)= (10.41*0.7) + (8.25*0.3)= 9.76% (approx)

The two projects mentioned have the same level of risk as each other and also same as the firm's existing assets. So the projects will be financed by both equity and debt. Thus, we will compare the Firm's cost of total capital (WACC) with the returns of both projects to check the feasibility. General rule:

If Return from new project > WACC (minimum return required by investors), accept the project

If Return from new project < WACC (minimum return required by investors), reject the project

If Return from new project =WACC (minimum return required by investors), accept the project/indifferent

As per the question,

Project A: Return 12% > WACC (9.76%), hence accept the project

Project B: Return 9% < WACC (9.76%), hence reject the project