Midwest Electric Company (MEC) uses only debt and common equity. It can borrow u
ID: 2748664 • Letter: M
Question
Midwest Electric Company (MEC) 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. MEC's tax rate is 40%. Two projects are available: Project A has a rate of return of 12%, while 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? Round your answer to two decimal places.
B.) What is the WACC? Round your answer to two decimal places.
C.) Which projects should Midwest accept?
Explanation / Answer
A.) cost pf equity(ke)= dividend next(D1)/current market price of share(p0)+growth
D1=D0+growth/100*D0
=$2.2+6/100*2.2
=$2.332
Ke=$2.332/$26+6%
=0.0897+0.06
=0.1497
=14.97%
B.)
after tax cost of debt Kd=Kd*(1-taxr ate)
=9%*(1-0.4)
5.4%
SOURCE OF FINANCE WEIGHT COST WCC
common equity 65% 14.97% 9.73
debt 35% 5.4% 1.89
11.62
C.) As project A has arate of rerturn of 12% and project B has a rate of return of 11%, project A should be accepted beacuse our WACC is then the rate of return of project A.