1. Bob’s Country Bunker (BCB), a chain of economically priced motels in the Midwestern United States has reviewed its current target structure of 40% debt and 60% equity. It can issue debt at a rate of 9%. The last dividend paid on its stock was $1.25. The company is doing very well and expects to maintain its current growth rate of 5%. The firm’s tax rate is 35%, and the common stock currently sells at $29. The company is considering two projects: Project A which has an expected rate of return of 14%, and Project B which has an expected rate of return of 10%. Both projects are equally risky and the firm can accept both.
a. What is the cost of common equity?
b. What is the WACC?
c. Which projects should BCB accept?
To calculate the cost of common equity for Bob's Country Bunker (BCB), you can use the dividend discount model (DDM) formula. The DDM formula calculates the cost of equity by dividing the expected dividend by the current stock price and adding the expected growth rate. Let's calculate it step by step:
a. Cost of common equity (Ke):
The formula for Ke is: Ke = (Dividend / Stock Price) + Growth Rate
Given:
- Dividend (D) = $1.25
- Stock Price (P) = $29
- Growth Rate (g) = 5% or 0.05
Ke = (1.25 / 29) + 0.05
Ke ≈ 0.0431 + 0.05
Ke ≈ 0.0931 or 9.31%
Therefore, the cost of common equity for BCB is approximately 9.31%.
b. Weighted Average Cost of Capital (WACC):
The WACC is the weighted average of the cost of debt (Kd) and the cost of equity (Ke), based on the target debt-to-equity ratio.
Given:
- Debt-to-equity ratio = 40% debt, 60% equity
- Cost of debt (Kd) = 9%
- Tax rate (T) = 35%
WACC = (Weight of Debt * Cost of Debt * (1 - Tax Rate)) + (Weight of Equity * Cost of Equity)
Weight of Debt = 40% or 0.4
Weight of Equity = 60% or 0.6
WACC = (0.4 * 0.09 * (1 - 0.35)) + (0.6 * 0.0931)
WACC ≈ 0.0336 + 0.0559
WACC ≈ 0.0895 or 8.95%
The WACC for BCB is approximately 8.95%.
c. Project selection:
To determine which projects BCB should accept, compare the expected rate of return for each project with the WACC.
For Project A:
Expected rate of return = 14%
WACC = 8.95%
Since the expected rate of return (14%) is higher than the WACC (8.95%), BCB should accept Project A.
For Project B:
Expected rate of return = 10%
WACC = 8.95%
Similarly, because the expected rate of return (10%) is also higher than the WACC (8.95%), BCB should accept Project B.
In conclusion, BCB should accept both Project A and Project B as they have expected rates of return higher than the WACC.