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WACC 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 35% debt and 65% common equity. Its last dividend (D0) was $2.20, its expected constant growth rate is 6%, and its common stock sells for $26. EEC's tax rate is 40%. Two projects are available: Project A has a rate of return of 12%. and Project B’s return is 11%. These two projects are equally risky and about as risky as the firm’s existing assets.
- a. What is its cost of common equity?
- b. What is the WACC?
- c. Which projects should Empire accept?
a.
To identify: The cost of common equity.
Introduction:
Cost of Equity:
It is the cost of the company while raising finance by issuing equity. It is the earnings from the investment to the firm’s equity investors. It is the return to the stockholder holders’ equity investments.
Given information:
Last dividend is $2.20 per share.
Growth rate is 6% or 0.06.
Current price of stock is $26.
Formula to calculate cost of common equity is,
Where,
-
-
- g is the constant growth rate.
Substitute $2
b.
To determine: Weighted average cost of capital.
Introduction:
Weighted Average Cost of Capital (WACC):
It is the weighted average cost of all the sources through which a firm finances its capital. It is the rate that a company will pay to all for raising finance. It can be termed as the firm’s cost of capital. The company raises money through various sources such as common stock and preference share debt. The WACC is calculated by taking the relative weight of each item of capital structure.
c.
To identify: The project that should be accepted by E Company.
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