Empire Electric Company (EEC) uses only debt and common equity. It can borrow unlimited amounts at an interest rate of rd = 11% as long as it finances at its target capital structure, which calls for 25% debt and 75% common equity. Its last dividend (D0) was $1.55, its expected constant growth rate is 6%, and its common stock sells for $29. EEC's tax rate is 25%. Two projects are available: Project A has a rate of return of 10%, and Project B's return is 11%. These two projects are equally risky and about as risky as the firm's existing assets.
What is its cost of common equity? Do not round intermediate calculations. Round your answer to two decimal places.
%
What is the WACC? Do not round intermediate calculations. Round your answer to two decimal places.
%
Which projects should Empire accept?
-Select-Project A OR Project B
(a)-Cost of Common Equity
Dividend in year 0 (D0) = $1.55 per share
Current selling price per share (P0) = $29.00 per share
Dividend growth Rate (g) = 6.00% per year
Therefore, the Cost of Common Stock = [D0(1 + g) / P0] + g
= [$1.55(1 + 0.06) / $29.00] + 0.06
= [$1.6430 / $29.00] + 0.06
= 0.0567 + 0.06
= 0.1167 or
= 11.67%
“The Cost of Common Equity = 11.67%”
(b)-Weighted Average Cost of Capital (WACC)
After Tax Cost of Debt
After Tax Cost of Debt = Borrowing Rate x [ 1 – Tax Rate]
= 11.00% x (1 – 0.25)
= 11.00% x 0.75
= 8.25%
Weighted Average Cost of Capital (WACC) = [After-tax cost of Debt x Weight of Debt] + [Cost of Equity x Weight of Equity]
= [8.25% x 0.25] + [11.67% x 0.75]
= 2.06% + 8.76%
= 10.82%
“Weighted Average Cost of Capital (WACC) will be 10.82%”
(c)- DECISION
“PROJECT-B” should be selected, Since the required rate of return of Project A (11%) is greater than the Weighted Average Cost of Capital of 10.82%.
Empire Electric Company (EEC) uses only debt and common equity. It can borrow unlimited amounts at...
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