The president and CFO of Spellman Transportation are having a disagreement about

Question

The president and CFO of Spellman Transportation are having a disagreement about whether to use market value or book value weights in calculating the WACC. Spellman's balance sheet shows a total of noncallable $45 million long-term debt with a coupon rate of 7.00% and a yield to maturity of 6.00%. This debt currently has a market value of $50 million. The company has 10 million shares of common stock, and the book value of the common equity (common stock plus retained earnings) is $65 million. The current stock price is $22.50 per share; stockholders' required return, rs, is 14.00%; and the firm's tax rate is 40%. The CFO thinks the WACC should be based on market value weights, but the president thinks book weights are more appropriate. What is the difference between these two WACCs?

Explanation / Answer

WACC taking book value weights:

Cost of debt=6(1-0.4)=3.6%

Weight of debt=45/(45+65)=0.41

Cost of equity=14%

Weight of equity=65/110=0.59

WACC=3.6*0.41+14*0.59=1.476+8.26=9.736%

WACC taking market value weights:

Market value of debt=$50 million

Market value of equity=22.5*10=$225 million

Cost of debt=6(1-0.4)=3.6%

Weight of debt=50/(50+225)=0.18

Cost of equity=14%

Weight of equity=225/(50+225)=0.82

WACC=3.6*0.18+14*0.82=0.648+11.48=12.128%

Difference between the two WACC=12.128-9.736=2.392%

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