Midwest Electric Company (MEC) uses only debt and common equity. It can borrow u
ID: 2765289 • 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 45% debt and 55% common equity. Its last dividend (D0) was $2.40, its expected constant growth rate is 4%, and its common stock sells for $24. MEC's tax rate is 40%. Two projects are available: Project A has a rate of return of 13%, while Project B's return is 8%. 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. % Which projects should Midwest accept, A or B?
Explanation / Answer
Cost of equity using constant growth model =(D1 / p) + g
D1 = D0 x (1+g)
= $2.40 x (1+ 0.04)
so, D1 = $2.496
Cost of equity = (2.496 / 24) + 0.04 = 14.40%
WACC = post tax cost of debt x weight of debt + cost of equity x weight of equity
= 11 x (1- 0.4) x 0.45 + 14.40 x 0.55
= 10.89%
Midwest should accept Project A as it has the higher rate of return then project B and since the cost of capital is 10.89%, project B would not give the desired results as its rate of return is below WACC.