Question

Midwest Electric Company (MEC) uses only debt and common equity. It can borrow unlimited amounts at an interest rate of r_d = 9% as long as it finances at its target capital structure, which calls for 25% debt and 75% common equity. Its last dividend (D₀) was $2.10, its expected constant growth rate is 3%, and its common stock sells for $20. MEC's tax rate is 40%. Two projects are available: Project A has a rate of return of 12%, while Project B's return is 9%. These two projects are equally risky and about as risky as the firm's existing assets.

1. 
   
2. What is its cost of common equity? Round your answer to two decimal places.
   %
3. 
   
4. What is the WACC? Round your answer to two decimal places.
   %
5. 
   
6. Which projects should Midwest accept?

Answer 1

(a)-Cost of Common Equity

Dividend in year 0 (D0) = $2.10 per share

Current selling price per share (P0) = $20.00 per share

Dividend growth Rate (g) = 3.00% per year

Therefore, the Cost of Common Stock = [D0(1 + g) / P0] + g

= [$2.10(1 + 0.03) / $20.00] + 0.03

= [$2.16 / $20.00] + 0.03

= 0.1082 + 0.03

= 0.1382 or

= 13.82%

“The Cost of Common Equity = 13.82%”

(b)-Weighted Average Cost of Capital (WACC)

After Tax Cost of Debt

After Tax Cost of Debt = Borrowing Rate x [ 1 – Tax Rate]

= 9.00% x (1 – 0.40)

= 9.00% x 0.60

= 5.40%

Weighted Average Cost of Capital (WACC) = [After-tax cost of Debt x Weight of Debt] + [Cost of Equity x Weight of Equity]

= [5.40% x 0.25] + [13.82% x 0.75]

= 1.35% + 10.37%

= 11.72%

“Weighted Average Cost of Capital (WACC) = 11.72%”

(c)- DECISION

“PROJECT-A” should be selected, Since the required rate of return (12.00%) of Project A is greater than the Weighted Average Cost of Capital of 11.72%.