UNIVERSITY OF THE IMMACULATE CONCEPTION

Bonifacio St., Davao City

MASTERS IN BUSINESS ADMINISTRATION

Financial Management

NINIO BIONG MANIALAG VINCENT RAY BORON, CPA, MBA

Student Professor

TLA 8. COST OF CAPITAL AND WACC

Instruction: Empire Electric Company (EEC) uses only debt and common equity. It can
borrow unlimited amounts at an interest rate of rd 9% as long as it finances at its target
capital structure, which calls for 35% debt and 65% common equity. Its last dividend D0 was
$2.20, its expected constant growth rate is 6%, and its common stock sells for $26. EEC’s
tax rate is 40%. Two projects are available: Project A has a rate of return of 12%, and Project
B’s return is 11%. These two projects are equally risky and about as risky as the firm’s
existing assets. 1. What is its cost of common equity?
2. What is the WACC?
3. Which projects should Empire accept? Explain.

Given:
Current dividend per share (D0) = $2.20
Growth rate (g) = 6%
Price of Common stock (P0) = $26.00
Before-tax cost of debt (rd) = 9%
Tax rate (T) = 40%
Project A rate of return = 12%
Project B rate of return = 11%

Required:
a.) Cost of common equity (re)
b.) WACC
c.) Projects to accept

a.) We can solve for the cost of common equity or retained earnings by using the
discounted cash flow approach (Gordon Growth Model).

re = D1 + g
P0
Where:
re = required return or cost of common equity
D1 = dividend after 1 period
P0 = current price per share
g = constant growth rate

Solve required return (re)

re = D1 + g
P0
= D0 (1+g) +g
P0

= $2.20 (1+6%) + 6%
$26.00

= $2.20 (1+0.06) + 6%
$26.00
= $2.20 (1.06) + 6%
$26.00
= $2.332 + 6%
$26.00
= 8.97% + 6%
re = 14.97%

b.) Find WACC:

WACC = wdrd (1-T) + were

= (35%)(9%)(1-40%) + (65%)(14.97%)
= (35%)(9%)(1.04)+(65%)(14.97%)
= (35%)(9%)(0.6)+(65%)(14.97%)
= 1.89%+9.73%
WACC = 11.62%

c.) Find which project(s) to accept:

Remember that WACC is the weighted average cost of capital. This is the weighted
average cost that is expected to be incurred when a firm raises capital for a project. For
project to be accepted, it’s expected rate of return should be higher than the cost. In this
case, project A’s rate of return is higher than the expected cost and may be accepted.
Project B should be rejected since its rate of return is lower than the WACC.