Problem 10-12 WACC Empire Electric Company (EEC) uses only debt and common equit

Question

Problem 10-12
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 35% debt and 65% common equity. Its last dividend (D0) was $2.70, its expected constant growth rate is 6%, and its common stock sells for $28. EEC's tax rate is 40%. Two projects are available: Project A has a rate of return of 13%, 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 or B Project B

Explanation / Answer

a.

Before tax cost of debt = 10%

Tax rate = 40%

After tax cost of debt = 10% × (1 - 40%)

= 6%

After tax cost of debt is 6%.

Cost of equity = [$2.70 × ( 1 + 6%) / $28] + 6%

= ($2.862 / $28) + 6%

= 10.22% + 6%

= 16.22%

Cost of equity is 16.22%.

Now, WACC is calculated below:

WACC = (65% × 16.22%) + (35% × 6%)

= 10.54% + 2.10%

= 12.64%

WACC of company is 12.64%.

b.

Project A provide 13% return and project B provides 8%. Since, cost of capital of company is 12.64%. so company should choose only those projects whose return is more than 12.64%. Project A provides 13% return that is more than cost of capital.

So, project A should be accepted.

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