Question

Click here to read the eBook: The Cost of Retained Earnings, rs Click here to read the eBook: Composite, or Weighted Average, Cost of Capital, WACC WACC Empire Electric Company (EEC) uses only debt and common equity. It can borrow unlimited amounts at an interest rate of rd = 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 $2.95, its expected constant growth rate is 4%, and its common stock sells for $21. EEC's tax rate is 40%. Two projects are available: Project A has a rate of return of 15%, and Project B's return is 8%. These two projects are equally risky and about as risky as the firm's existing assets. What is its cost of common equity? Round your answer to two decimal places. Do not round your intermediate calculations. % What is the WACC? Round your answer to two decimal places. Do not round your intermediate calculations. % Which projects should Empire accept? -Select-Project A Project B

Answer 1

(a)-Cost of Common Equity

Dividend in year 0 (D0) = $2.95 per share

Current selling price per share (P0) = $21.00 per share

Dividend growth Rate (g) = 4.00% per year

Therefore, the Cost of Common Stock = [D0(1 + g) / P0] + g

= [$2.95(1 + 0.04) / $21.00] + 0.04

= [$3.0680 / $21.00] + 0.04

= 0.1461 + 0.04

= 0.1861 or

= 18.61%

“The Cost of Common Equity = 18.61%”

(b)-Weighted Average Cost of Capital (WACC)

After Tax Cost of Debt

After Tax Cost of Debt = Borrowing Rate x [ 1 – Tax Rate]

= 10.00% x (1 – 0.40)

= 10.00% x 0.60

= 6.00%

Weighted Average Cost of Capital (WACC) = [After-tax cost of Debt x Weight of Debt] + [Cost of Equity x Weight of Equity]

= [6.00% x 0.30] + [18.61% x 0.70]

= 1.80% + 13.03%

= 14.83%

“Weighted Average Cost of Capital (WACC) = 14.83%”

(c)- DECISION

“PROJECT-A” should be selected, Since the required rate of return (15%) of Project A is greater than the Weighted Average Cost of Capital of 14.83%.