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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

WACC Midwest Electric Company (MKC) 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 45% debt and 55% common equity. Its last dividend (D0) was $2, its expected constant growth rate is 4%, and its common stock sells for $20. 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 10%. These two projects are equally risky and about as risky as the firm’s existing assets.

  1. a. What is its cost of common equity?
  2. b. What is the WACC?
  3. c. Which projects should Midwest accept?

a.

Summary Introduction

To identify: The cost of common equity.

Cost of Equity:

It is the cost of the company while raising finance by issuing equity. It is earnings from the investment to the firm’s equity investors. It is the return to the stockholder holders’ equity investments.

Explanation

Given,

Last dividend is $2 per share.

Growth rate is 4%.

Current price of stock is $20.

Formula to calculate cost of common equity is,

r=D0(1+g)P0+g

Where,

  • D0 is the last dividend.
  • P0 is the current price of the stock.
  • g is the constant growth rate

b.

Summary Introduction

To determine: Weighted average cost of capital.

Weighted Average Cost of Capital (WACC):

It is the weighted average cost of all the sources through which firm finances its capital. It is that rate that company will pay to all for raising finance. It can be termed as firm’s cost of capital.

The company raises money through various sources such as common stock, preference share debt the WACC is calculated taking the relative weight of each item of capital structure.

The formula to calculate WACC is,

WACC=Wdrd(1t)+WPrp+Wcrs

Where,

  • Wd is the weight of the debt.
  • WP is the weight of the preferred stock.
  • Wc is the weight of the equity.
  • rd is cost of the debt.
  • rP is cost of the preferred stock.
  • rc is the cost of the equity.
  • t is the tax rate.

c.

Summary Introduction

To identify: The project that should be accepted by M Company.

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