eBook Problem 10-12 Empire Electric ompany E uses only debt and com mon equity t
ID: 2795712 • Letter: E
Question
eBook Problem 10-12 Empire Electric ompany E uses only debt and com mon equity t can borro w unlimited amounts at an interest ate o r i0% as long as it finances at its target capital structure, rhich is fo 4 ot and 5 %common equity t last dividend Do) was $2.80 its expected constant growth ate is 39 and its common stock sells for $26. EE s tax rate is 40% T o projects are available: Proet A as a ateofreturnof ar d ro ec s returns % These two ro ects 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 c. Which projects should Empire accept? Check My Work (a remaining)Explanation / Answer
Calculation of cost of equity:
Growth rate 3%
Current price of the stock $26
Dividend paid $2.80
By using DDM model,
Value of stock = Last Dividend * ( 1 + growth rate) / Cost of equity - growth rate
$26 = 2.80 * (1+.03) / cost of equity - .03
cost of equity - .03 = 2.884 / 26
or, cost of equity = 14.09%
b) Cost of debt = 10%, Tax rate = 40%, Debt's weight = 45%, Equity's weight = 55%
WACC = 45%*10% *(1-40%)+ 55%*14.09% = 0.027 + 0.077495 = 0.104495 or 10.45%
WACC is 10.45%
c) Rate of return of project A is 12% and B is 10%. The company should choose that project which whose return is more than WACC. Accordingly, Project A should be accepted because Project B's return is less than WACC.
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