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10-12. 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 45% debt and 55% common equity. Its last
dividend was $2, its expected constant growth rate is 4%, and is common stock sells for
$20. MECs tax rate is 40%. Two projects 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
risky as the firms existing assets. a. What is the cost of common equity? b. What is
the WACC? c. Which projects should Midwest accept?

a. rd = 10%, rd(1 T) = 10%(0.6) = 6%.

D/A = 45%; D0 = $2; g = 4%; P0 = $20; T = 40%.

Project A: Rate of return = 13%.


Project B: Rate of return = 10%.
rs = $2(1.04)/$20 + 4% = 14.40%.
b. WACC = 0.45(6%) + 0.55(14.40%) = 10.62%.
c. Since the firms WACC is 10.62% and each of the projects is equally risky and
as risky as the firms other assets, MEC should accept Project A. Its rate of
return is greater than the firms WACC. Project B should not be accepted,
since its rate of return is less than MECs WACC.