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Project Evaluation using WACC for Jake's (Bob Country) Bunker

Jake's Bunker (Bob's Country Bunker), 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 risking and the firm can accept both. Show your work.

a. What is the cost of common equity?
b. What is the WACC?
c. Which projects should Jakes Business accept?

Solution Preview

a. What is the cost of common equity?

The Gordon Dividend Growth Model states that :

Current Price = Next Dividend/(Required rate of return - estimated growth rate)

Thus,

Current Price = Next Dividend/(Required rate of return - ...

Solution Summary

This solution illustrates how to compute a firm's cost of equity and weighted-average cost of capital, and how to apply that knowledge to evaluating and choosing projects in which to invest. This solution includes formulas, calculations and answers.

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