Question

(1 -3) Midwest Electric Company (MEC) uses only debt and equity. It can borrow unlimited amounts at an interest rate of 10% as long as it finances as it its target capital structure, which calls for 45% debt and 55% common equity. Its last divided was Php 2, its expected constant growth rate 4%, and its stock sells at a price of Php 20. MEC's tax rate is 40%. Two projects are available: Project A has a rate of return of 13%, while Project B has a rate of 10%. All of the company's potential projects are equally risky and as risky as the firm's other assets. With the above, answer the following questions: 1. MEC's cost of common equity a. 10.0% b. 14.0% c. 14.4% d. 13.0% e. None of the above 2. MEC'S WAAC? a. 12.42% b. 10.62% c. 10.40% d. 9.85% e. None of the Above 3. Which project should MEC select and why? a. Any of the Projects since both have rates of return higher than WACC. b. Accept Project B since its rate of return is closest to the WACC and thus less risky c. Accept Project A with a higher return since WACC is irrelevant. d. Accept Project A since its rate of return is higher than WACC. e. Reject both Projects since it is not worth the investment.

Answer 1

Answer a.

Last dividend (D0)= 2

Growth rate (g) =4%

Current price (P)= 20

Cost of equity formula (ke)= (D0*(1+g)/P0 ) + g

(2*(1+4%)/20) +4%

=0.144 or 14.4%

So cost of common equity is 14.4%

b.

WACC = (weight of debt * cost of debt*(1-tax rate)) + (weight of equity * cost of equity)

(45%*10%(1-40%)) + (55%*14.4%)

=0.1062 or 10.62%

So Weighted average cost of capital is 10.62%

c.

Projects having Rate of return exceeding or equal to WACC should be accepted.

otherwise project should not be accepted.

Project A return 13% is higher than WACC of 10.62%. So it should be accepted.

Project B return 10% is lower than WACC of 10.62%. so it should not be accepted.

So correct option is d, Accept Project A since its rate of return is higher than WACC.