Midwest Electric Company (MEC) uses only debt and common equity. It can borrow u
ID: 2763497 • 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 40% debt and 60% common equity. Its last dividend (D0) was $1.85, 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 10%, while Project B's return is 12%. 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
a. The cost of equity is given the dividend distribution model (DDM)
Cost of equity = Ke = D1/P0 + g
D1 = D0*(1+g) = 1.85*(1+0.04) = 1.85*1.04 = 1.924
P0 = 21
g = 0.04
Cost of equity = ke = 1.924/21 + 0.04 = 0.1316 = 13.16%
b. The Cost of debt (preatax) = 11%
Post tax cost of debt = Rd = Pretax rate*(1-tax rate) = 11*(1-0.4) = 6.6%
WACC = We* Re + Wd* Rd
Re = 13.16%, Rd =6.6%, We = 0.6 , Wd =0.4
WACC = 0.6*13.16% + 0.4*6.6% = 10.536%
WACC = 10.54%(Rounded to two decimals)