7. Westerly Manufacturing has compiled the information shown in the following ta

Question

7. Westerly Manufacturing has compiled the information shown in the following table:

Source of Capital            Book  Value                 Market Value             After-tax Cost
Long-Term Debt             $4,000,000                   $3,840,000               6.0%
Preferred Stock              $40,000                        $60,000                    13.0%
Common Stock Equity       $1,060,000                   $3,000,000                17.0%
Totals                             $5,100,000                 $6,900,000

(a) Calculate the firm’s weighted average cost of capital (WACC) using book value weights.
(b) Calculate the firm’s weighted average cost of capital (WACC) using market value weights.
(c) Compare your answers found in parts (a) and (b) and briefly explain the differences. Other things equal, would you recommend that Westerly Manufacturing rely on its book value weights or market value weights in determining its WACC?

Explanation / Answer

a) 4,000/5,100 *.06 + 40/5,100 * .13 +1,060/5,100 = 8.34% b) 3,840/6,900* .06 +60/6,900*.13 +3000/6,900 *.17= 10.84% c) Differences are due to the fact that book value of debt is below market value (low after tax cost) and book value of common stock is below market value (high after tax cost). Market value is a better measure because it reflects what the market is willing to pay for the financial instrument and thus better estimates the expectations of the market on returns to each type of financing.

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