Florida Electric Company (FEC) uses only debt and equity. It can borrow unlimite

Question

Florida Electric Company (FEC) uses only debt and equity. It can borrow unlimited amounts at an interest rate of 10 percent as long as it finances at its target capital structure, which calls for 45 percent debt and 55 percent common equity. Its last dividend was $2, its expected constant growth rate is 4 percent, its stock sells at a price of $25, and new stock would net the company $20 per share after flotation costs. FEC’s marginal tax rate is 40 percent, and it expects to have $100 million of retained earnings this year. Two projects are available: Project A has a cost of $200 million and an expected return of 13 percent, and Project B has a cost of $125 million and an expected return of 10 percent. All of the company’s potential projects are equally risky. a. What is FEC's cost of equity form newly issued stock? b. What is FEC's marginal cost of capital-that is, what WACC cost rate should it use to evaluate projects (these two projects plus any others that may arise during the year, provided the cost of capital schedule remains as it is currently)?

Explanation / Answer

a. Cost of equity

Using Gordon's Growth Model, Price of equity, P = D1/(Ke - g)

D1 = Dividend in year 1; Ke = cost of equity, g = growth rate

D1=D0(1+g) = $2x1.04 = $2.08

Using the above equation, $20 = $2.08/(ke-0.04)

ie. ke = 14.4%

b. FEC's WACC

WACC = (Cost of Debt x Proportion of Debt)x(1-tax rate) + (Cost of Equity x Proportion of Equity)

= 0.1x0.45x(1-0.4) + 0.144x0.55

= 10.62%

So, select only those projects which gives a return above 10.62%

Related Questions

Navigate

• Browse (All)
• Browse F
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.