Problem 10-12 WACC Midwest Electric Company (MEC) uses only debt and common equi
ID: 2718705 • Letter: P
Question
Problem 10-12
WACC
Midwest Electric Company (MEC) 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 40% debt and 60% common equity. Its last dividend (D0) was $1.90, its expected constant growth rate is 6%, and its common stock sells for $29. 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.
What is its cost of common equity? Round your answer to two decimal places.
%
What is the WACC? Round your answer to two decimal places.
%
Which projects should Midwest accept?
Problem 10-12
WACC
Midwest Electric Company (MEC) 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 40% debt and 60% common equity. Its last dividend (D0) was $1.90, its expected constant growth rate is 6%, and its common stock sells for $29. 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.
What is its cost of common equity? Round your answer to two decimal places.
%
What is the WACC? Round your answer to two decimal places.
%
Which projects should Midwest accept?
Explanation / Answer
Cost of common equity Using dividend growth model= (Next year's annual dividend/current stock price)+dividend growth rate
Next year annual dividend = 1.90 x 6% =2.04
Cost of common equity =( 2.04/29)+6%=13%
WACC = E/V x re+D/V x rdx(1-tc)
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
WACC = 60% x 13%+40%x 11%(1-40%)
WACC = 0.6x0.13+0.4x0.11x(1-0.40)
WACC = 10.44%
Project A should be accepted because its rate of return(15%) is greater than Weighted Average Cost of capital(10.44%).
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