Problem 10-12 WACC Midwest Electric Company (MEC) uses only debt and common equi

Question

Problem 10-12
WACC

Midwest Electric Company (MEC) 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 35% debt and 65% common equity. Its last dividend (D0) was $2.50, its expected constant growth rate is 6%, and its common stock sells for $28. MEC's tax rate is 40%. Two projects are available: Project A has a rate of return of 14%, while 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.
%

What is the WACC? Round your answer to two decimal places.
%

Explanation / Answer

Cost of Equity = Dividends per share ( for Next year) / Current market value of stock + Growth rate of Dividends

= Last year Dividends * (1 + Growth rate of Dividends) / Current market value of stock + Growth rate of Dividends

= $2.50 * (1 + 6%) / $28 + 6%

= 15.46%

Now, WACC = Cost of debt * (1 - tax rate) * Weightage of debt + Cost of equity * Weightage of equity

= 10% * (1 - 40%) * 35% + 15.46% * 65%

= 12.15%

Therefore, Cost of equity = 15.46% and WACC = 12.15%

Also, Project A can be accepted as its return (14%) is higher than the WACC. However, the Project B has to rejected as the its return (8%) is less than WACC.

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