Midwest Electric Company (MEC) uses only debt and common equity. It can borrow u
ID: 2763007 • Letter: M
Question
Midwest Electric Company (MEC) uses only debt and common equity. It can borrow unlimited amounts at an interest rate of rd = 11% as long as it finances at its target capital structure, which calls for 30% debt and 70% common equity. Its last dividend (D0) was $2.05, its expected constant growth rate is 5%, and its common stock sells for $29. MEC's tax rate is 40%. Two projects are available: Project A has a rate of return of 14%, while Project B's return is 9%. These two projects are equally risky and about as risky as the firm's existing assets. What is its cost of common equity? Round your answer to two decimal places. % What is the WACC? Round your answer to two decimal places. %
Explanation / Answer
Current Price of Stock as per Constant Growth Dividend Model is calculated as = D1 / (Re - g) where, D1 is expected dividend to be paid in the next period Re is the required rate of return g is the constant growth rate or, 29 = (2.05 * 1.05 )/ (Re - 0.05) or, 29( Re - 0.05) = 2.1525 or, 29Re - 1.45 = 2.1525 or, 29 Re = 3.6025 or, Re = 3.6025/29 = 12.4224% Common Cost of Equity = 12.42% Cost of Debt = 11% After tax cost of Debt = 11% * (1-tax rate) = 11% * (1-0.29) = 7.81% WACC = Wd*Kd + We * Ke where Wd and We are weights of debt and equity WACC = 30% * 7.81% + 70% * 12.42% = 2.343% + 8.696% = 11.04%