Midwest Electric Company (MEC) uses only debt and common equity. It can borrow u
ID: 2763424 • 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 40% debt and 60% common equity. Its last dividend (D0) was $3.25, its expected constant growth rate is 3%, 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 9%. 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?
Explanation / Answer
Cost of Equity = D/P0 +G = 3.25/26 + 3% = 15.5% Weighted average Cost of Capital Rate of Return before tax Rate of Return after tax Cost of capital Debt 40% 9% 5.4% 2.16% Equity 60% 15.50% 15.50% 9.30% WACC ` 11.46%