WACC Midwest Electric Company MEC uses only debt and common

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?

Solution

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