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 45% debt and 55% common equity. Its last dividend (D0) was $1.95, its expected constant growth rate is 4%, and its common stock sells for $26. EEC's tax rate is 40%. Two projects are available: Project A has a rate of return of 11%, 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? 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?

Explanation / Answer

Answer a.

Last Dividend, D0 = $1.95
growth rate, g = 4%
Current Price, P0 = $26

D1 = $1.95 * 1.04
D1 = $2.028

Cost of Common Equity, rs = D1 / P0 + g
Cost of Common Equity, rs = $2.028 / $26 + 0.04
Cost of Common Equity, rs = 0.118
Cost of Common Equity, rs = 11.80%

Answer b.

Weight of Common Stock, ws = 55%
Weight of Debt, rd = 45%
Cost of Debt, rd = 10%
Cost of Common Equity, rs = 11.80%

WACC = ws * rs + wd * rd * (1 - tax)
WACC = 55% * 11.80% + 45% * 10% * (1 - 0.40)
WACC = 9.19%

Answer c.

So, Empire should accept Project A as its rate of return is higher than WACC.

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