Midwest Electric Company (MEC) uses only debt and common equity. It can borrow u
ID: 2768570 • Letter: M
Question
Midwest Electric Company (MEC) uses only debt and common equity. It can borrow unlimited amounts at an interest rate of rd = 10% as long as it finances at its target capital structure, which calls for 30% debt and 70% common equity. Its last dividend (D0) was $3.05, its expected constant growth rate is 3%, 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 14%, while Project B's return is 11%. These two projects are equally risky and about as risky as the firm's existing assets.
a. What is its cost of common equity? Round your answer to two decimal places.
____%
b. What is the WACC? Round your answer to two decimal places.
____%
Explanation / Answer
(a) Stock Price P = D0 (1+g) / (k – g)
Where:
P = the current stock price = $ 24
D0 = dividend for year = $ 3.05
k = required rate of return = ?
g = growth rate of dividends = 3% = 0.03
Therefore
24 = 3.05(1+0.03) / (k – 0.03)
Or k – 0.03 = 3.14 / 24 = 0.1309
Or k = 0.1309 + 0.03 = 0.1609 = 16.09%
Required rate of return or Cost of common equity is 16.09%
(b) WACC = {rd (1- Tc )*( D / V )}+{ re *( E / V )}
rd = The required return of the firm's Debt financing = 10% =0.1
Tc = Tax rate = 40% = 0.4
(D/V) = (Debt/Total Value) = 0.3/1
re= the firm's cost of equity = 16.09% = 0.1609
(E/V) = (Equity/Total Value) = 0.7/1
Therefore
WACC = {0.1* (1-0.4) * (0.3/1) } + { 0.1609 *(0.7/1)}
= 0.018 + 0.1126 = 0.1306 = 13.06%