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.

Question

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?

Answer 1

To calculate the cost of common equity (Ke), we can apply the Dividend Discount Model (DDM) which takes into account the current stock price, the expected growth rate, and the last dividend paid. The formula for Ke is as follows:

Ke = (Dividend / Stock Price) + Growth Rate

Given that the last dividend paid is $1.25, the stock price is $29, and the growth rate is 5%, we can substitute these values into the formula to find Ke:

Ke = (1.25 / 29) + 0.05
Ke ≈ 0.0431 + 0.05
Ke ≈ 0.0931, or 9.31%

So, the cost of common equity (Ke) for BCB is approximately 9.31%.

To calculate the weighted average cost of capital (WACC), we need to take into account both the cost of debt and the cost of equity. The formula for WACC is as follows:

WACC = (Weight of Debt × Cost of Debt) + (Weight of Equity × Cost of Equity)

Given that BCB's target structure is 40% debt and 60% equity, and the cost of debt is 9% (as mentioned in the question), we can substitute these values into the formula to find WACC:

WACC = (0.40 × 0.09) + (0.60 × 0.0931)
WACC ≈ 0.036 + 0.05586
WACC ≈ 0.09186, or 9.186%

So, the weighted average cost of capital (WACC) for BCB is approximately 9.186%.

To determine which projects BCB should accept, we can compare the expected rate of return for each project with the WACC. If the expected rate of return is higher than the WACC, the project is expected to generate a return higher than the cost of capital, making it a good investment.

For Project A, the expected rate of return is 14%, which is higher than the WACC of 9.186%. Therefore, Project A should be accepted.

For Project B, the expected rate of return is 10%, which is also higher than the WACC. Therefore, Project B should be accepted as well.

In summary, BCB should accept both Project A and Project B since both projects offer returns that are higher than the firm's weighted average cost of capital (WACC).