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The cost of common equity represents the return that a company must earn on its equity-financed investments to maintain its stock price. It reflects the compensation investors expect for their investment risk. Calculating this figure helps a firm to gauge how much return needs to be generated by projects that are financed through equity. Here, the Midwest Electric Company (MEC) uses the Dividend Discount Model (DDM), also known as the Gordon Growth Model, to determine their cost of common equity. This model estimates the cost of equity capital when the dividends are expected to grow at a constant rate. To find it, you apply the formula: \[ r_s = \frac{D_1}{P_0} + g \] where

• \(D_1\) is the expected dividend in the next period (calculated as the last dividend \(D_0\) multiplied by \(1 + g\), the growth rate).
• \(P_0\) is the current price of the stock.
• \(g\) is the expected growth rate of dividends.

For MEC,

• \(D_0\) was \\(2, and with a growth rate \(g\) of 4%, \(D_1\) becomes \\)2.08.
• With a stock price \(P_0\) of \$20, the cost of common equity, \(r_s\), is \(10.4\%\).

The Dividend Discount Model is pivotal in determining the cost of equity. It assesses a stock's value based on its expected future dividends, which makes it very useful. This model is built on the premise that a stock is worth the sum of all its future dividend payments, discounted back to its present value. The simplicity of the DDM makes it widely used, although it assumes a constant growth rate. There are key assumptions in the model:

• The company will continue to pay dividends perpetually.
• The rate of growth for dividends is constant.
• The expected rate of return stays above the growth rate.

While these assumptions align well with stable companies like MEC, they may not fit with firms experiencing rapid growth or highly variable dividends. Still, when applicable, the DDM offers a straightforward way to find out how much investors are justified in expecting in returns, as this directly impacts their willingness to buy the stock.

Project evaluation involves determining which ventures or investments will bring value to a company. For MEC, the project's returns need to be compared to the Weighted Average Cost of Capital (WACC). WACC is important because it represents the average rate a company needs to pay to finance its assets. Hence, any project must generate returns greater than the WACC to be considered financially beneficial. To elaborate:

• Project A has a return of 13%, which exceeds the calculated WACC of 8.42%.
• Project B has a return of 10%, which also surpasses the WACC.
• Both projects, by surpassing the WACC threshold, are deemed viable and beneficial investments.

Choosing these projects means MEC will be using their funds efficiently to add value. This evaluation process underscores the importance of aligning project returns with cost of capital to ensure shareholder wealth is maximized.