Question
Midwest Electric Company (MEC) uses only debt and common equity. It can borrow unlimited amount at an interest rate of r d =10% as long
Midwest Electric Company (MEC) uses only debt and common equity. It can borrow unlimited amount at an interest rate of rd=10% as long as it finances at its target capital structure, which calls for 45% debt and 55% common equity. Its last dividends (D0) was $2, its expected constant growth rate is 4%, and its common stock sells for $20. MECs tax rate is 40%. Two project are available: Project A has a rate of return of 13%, while Project Bs return is 10%. These two projects are equally risky and about as risk as exiting assets.
- What is its cost of common equity
- What is the WACC
- Which projects should Midwest accept?
Here is the summarized four average risk projects with their rate of returns for Skye Computer Company
Project Name | Expected Rate of Return |
1- Building Hospital | 17.00% |
2- Building School | 16.00% |
3- Building Stadium | 10% |
4- Building Park | 11.26% |
The common stock sells for $55.00, last years dividend D0 was $2.10, and a flotation cost of 10% would be required to sell new common stock. Security analysts are projecting that the common dividend will grow at an annual rate of 9%. Skye's preferred stock pays a dividend of $3.30 per share, and its preferred stock sells for $30 per share. The firm can issue long-term debt at an interest rate (or before-tax cost) of 10%, and its marginal tax rate is 35%. The firm's currently outstanding 10% annual coupon rate long-term debt sells at par value. The market risk premium is 5%, the risk-free rate is 6%, and Skye's beta is 1.516. In its cost of capital calculations, the companys capital structure consists of 64.7% common stock, 28.2% debt, and 7.1% preferred stock.
- Calculate the cost of each capital component, that is, the after-tax cost of debt, the cost of preferred stock, the cost of equity from retained earnings, and the cost of newly issued common stock.
- If Skye continues to use the same capital structure, what is the firm's WACC assuming that it expands so rapidly that is must issue new common stock?
- Assume that all projects are equally risky and based on WACC, which project should Skye Computer Companyaccept and which to be rejected? Explain why?
- Smith Technologies has a WACC of 14%, and is currently evaluating two projects for this years capital budget. Project A has a cost of $6000 and its expected cash inflows are $2000 for 5 years. Project B has a cost of $18000 and its expected cash inflows are $5600 for 5 years.
- a. Calculate NPV, IRR, payback for each project.
- b. Assuming the projects are independent which one(s) would you recommend for each method? Why?
- c. If the projects are mutually exclusive, which would you recommend for each method? Why?
A Vivical Company is considering a new project and must choose between the following mutually exclusive projects:
- Project A: Establishing Advertising Agency
- Project B: Establishing Travel Agency
The firm could spend $10,000 on Project A. Its expected cash inflows of $4,000 during the first 2 years while the third and fourth years, cash flow will increase by $200 each year.
However, project B would cost $ 15,000. Its expected cash inflow is $4,800 for first year and is expected to increase by $150 every year.
- Draw the timeline for both projects and find the NPV, IRR, and Payback Period for both projects Advertising Agency and Travel Agency.
- Based on NPV and IRR valuation methods, which project should Vivical Company accept and which should they reject? Explain why.
Vivical has a WACC of 15%
Patchi Chocolate Co. expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, its expected constant dividend growth rate is 6.0%, and its common stock currently sells for $32.50 per share. New stock can be sold to the public at the current price, but a flotation cost of 5% would be incurred. What would be the cost of equity from new common stock?
LaPango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?
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