Question

Brigham Chapter 10 End-of-Chapter Problems 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 = 9% as long as it finances at its target capital structure, which calls for 30% debt and 70% common equity. Its last dividend (Do) was $2.95, its expected

Answer 1

Weight of Debt = 30%
Weight of Equity = 70%

Before-tax Cost of Debt = 9.00%
Tax Rate = 40%

After-tax Cost of Debt = Before-tax Cost of Debt * (1 - Tax Rate)
After-tax Cost of Debt = 9.00% * (1 - 0.40)
After-tax Cost of Debt = 5.40%

Last Dividend, D0 = $2.95
Current Price, P0 = $22.00
Growth Rate, g = 3.00%

D1 = D0 * (1 + g)
D1 = $2.95 * 1.03
D1 = $3.0385

Cost of Equity = D1 / P0 + g
Cost of Equity = $3.0385 / $22.00 + 0.03
Cost of Equity = 0.1681 or 16.81%

WACC = Weight of Debt * After-tax Cost of Debt + Weight of Equity * Cost of Equity
WACC = 0.30 * 5.40% + 0.70 * 16.81%
WACC = 13.39%

Empire should accept Project A as its required return is higher than the WACC.