WACC Midwest Electric Company (MEC) uses only debt and common equity. It can bor

Question

WACC Midwest Electric Company (MEC) uses only debt and common equity. It can borrow unlimited amounts at an interest rate of rd = 9% as long as it finances at its target capital structure, which calls for 45% debt and 55% common equity. Its last dividend (D_0) was $3.10, its expected constant growth rate is 5%, and its common stock sells for $23. MEC's tax rate is 40%. Two projects are available: Project A has a rate of return of 13%, while 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? 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

rd = 9%, rd(1 – T) = 9%(0.6) = 5.4%.D/A = 45%; D0= $3.10; g = 5%; P0= $23 T = 40%.

Project A: Rate of return = 13%.

Project B: Rate of return = 11%.

rs = $3.10(1.05)/$23 + 5% = 19.15%.

b.   WACC = 0.45(5.4%) + 0.55(19.15%) = 12.96%.

c.   Since the firm’s WACC is 12.96% and each of the projects is equally risky and as risky as the firm’s other assets, MEC should accept Project A. Its rate of return is greater than the firm’s WACC. Project B should not be accepted, since its rate of return is less than MEC’s WACC.

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