Midwest Electric Company (MEC) uses only debt and common equity. It can borrow u
ID: 2763449 • 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? (Hint: not 3.25/26 + 3% = 15.5%)
b. What is the WACC? (hint: not 11.46%)
Explanation / Answer
a. Equity price = Dividend paid * (1 + dividend growth) / (Cost of equity - Dividend growth)
=> $26 = $3.25 * (1 + 3%) / (Cost of equity - 3%)
=> Cost of equity = 15.875%
b. WACC = 40% * 9% * (1 - 40%) + 60% * 15.875%
= 11.685%