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Empire Electric Company (EEC) uses only debt and common equity
Empire Electric Company (EEC) 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 40% debt and 60% common equity. Its last dividend (D0) was $2.20, its expected constant growth rate is 6%, and its common stock sells for $27. EEC's tax rate is 25%. Two projects are available: Project A has a rate of return of 11%, and Project B's return is 12%. These two projects are equally risky and about as risky as the firm's existing assets.
a. What is its cost of common equity? Do not round intermediate calculations. Round your answer to two decimal places.
%
b. What is the WACC? Do not round intermediate calculations. Round your answer to two decimal places.
%
c. Which projects should Empire accept?
-Select- Project A or Project B
Expert Solution
a) Computation of Cost of Common Equity:
Stock Price = Expected Dividend/(Cost of Common Equity - Growth Rate)
$27 = $2.20*(1+6%)/(Cost of Common Equity - 6%)
$27 = $2.332 / (Cost of Common Equity - 6%)
Cost of Common Equity = $2.332/$27 + 6%
Cost of Common Equity = 14.64%
b) Computation of WACC:
WACC = Cost of Debt*Weight of Debt + Cost of Common Stock*Weight of Common Stock
= 9%*(1-25%)*40% + 14.64%*60%
WACC = 11.48%
c. Acceptable projects are those whose return is higher than WACC i.e. Project B. Project B has higher return than WACC.
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