Midwest Electric Company (MEC) uses only debt and common equity. It can borrow u
ID: 2762723 • Letter: M
Question
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 30% debt and 70% common equity. Its last dividend (D0) was $1.95, its expected constant growth rate is 4%, 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 8%. These two projects are equally risky and about as risky as the firm's existing assets
Explanation / Answer
Interest rate on debt (rd) = 10%
tax rate = 40%
cost of debt = interest*(1-tax)
= 10%* (1-0.40)
= 6%
Cost of equity = [D0*(1+g) / P0 ] + g
where, D0 = $1.95
g = growth rate = 4%
p0 = price of share = $21
Cost of equity Ke = $1.95*(1+0.04) / $21 + 0.04
= 13.66%
Weighted average cost of capital of MEC = weight of equity * cost of equity + weight of debt * cost of debt
= 13.66 * (70/100) + 6% * (30/100)
= 11.362%
If project A has rate of return 15%, then it would be accepted as the cost of capital is less than requied rate of return.... 15% > 11.36 %
If project B has rate of return 8%, then it would not be accepted as the cost of capital is higher than requied rate of return.... 8 % < 11.36 %.
hence invest in Project A