WACC Midwest Electric Company (MEC) uses only debt and common equity. It can bor
ID: 2701816 • Letter: W
Question
WACC
Midwest Electric Company (MEC) 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 40% debt and 60% common equity. Its last dividend (D0) was $2.05, its expected constant growth rate is 4%, and its common stock sells for $28. MEC's tax rate is 40%. Two projects are available: Project A has a rate of return of 15%, while Project B's return is 9%. These two projects are equally risky and about as risky as the firm's existing assets.
Explanation / Answer
cost of common equity = 2.05 * 1.04 / 28 + 0.04 = 11.61%
after tax cost of debt rd = 10% * (1-0.4) = 6%
WACC = 0.4 * 6% + 0.6 * 11.61% = 9.366%
MEC should accept Project A. Its rate of return is greater than the firm%u2019s WACC. Project B should not be accepted, since its rate of return is less than MEC%u2019s WACC.
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