WACC Midwest Electric Company (MEC) uses only debt and common equity. It can bor
ID: 2763882 • 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 = 9% as long as it finances at its target capital structure, which calls for 35% debt and 65% common equity. Its last dividend (D0) was $2.60, its expected constant growth rate is 4%, 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.
Explanation / Answer
AFTER TAX COST OF DEBT
Rd = INTEREST RATE (1 - TAX RATE)
= 9% (1 - 0.40)
= 5.40%
COST OF EQUITY
Ke = (D1 / CURRENT PRICE) + GROWTH
= [($2.60 * 1.04) / $23] + 0.04
= 0.1174 + 0.04
= 0.1574 OR 15.74%
WACC
= 5.40% * 0.35 + 15.74% * 0.65
= 1.89 + 10.23%
= 12.12%
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PROJECT A SHOULD BE ACCEPTED BECAUSE IT'S RATE OF RETURN IS MORE THAN WACC.
PROJECT B SHOULD NOT BE ACCEPTED BECAUSE IT'S RATE OF RETURN IS LESS THAN WACC.
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