WACC Midwest Electric Company (MEC) uses only debt and common equity. It can bor
ID: 3003942 • 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 25% debt and 75% common equity. Its last dividend (D0) was $2.05, its expected constant growth rate is 6%, and its common stock sells for $21. 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 12%. 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 =(2* next period dividend by current stock price)+growth rate
=(2*1.06/21)+0.06=169/1050=0.160952380952
Hence cost of common equity is apprx 16.1 %
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WAAC (Weighted average cost of the capital)= cost of the debt + cost of equity
WAAC= cost of debt * ratio of debt to total capital * (1- tax rate)+ cost of common equity * ratio of common equity to total capital
WAAC= 10%* 0.25 * (1-0.40)+16.10% *0.75
WAAC= 0.10* 0.25 * (1-0.40)+0.161 *0.75=0.13575
which is approx WAAC=13.58%
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Midwest should accept project A because it has higher return than the WACC
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