Midwest Electric Company (MEC) uses only debt and common equity. It can borrow u
ID: 402226 • 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 50% debt and 50% common equity. Its last dividend was $2.50, its expected constant growth rate is 5%, and its common stock sells for $30. 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 also 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
Here we have to find the after tax cost of debt (its after tax because debt interest is tax deductible meaning you can remove interest expense from your taxable income) and the cost of equity.
After-tax cost of debt = rd x (1-tax rate) = 10% x (1-0.4) = 6%
Cost of equity if found by the dividend discount model:
FV = (D x (1+g))/(r-g) = 30 = (2.50 x (1.05))/(r-.05) and you solve for r. Solving for r you get 13.75%. This is the cost of equity.
The WACC is just the fraction of each form of capital times it's rate (After tax cost of debt and cost of equity.)
WACC = (.1375) x (0.50) + (.06) x (0.50) = 9.875% which is the WACC.