WACC long dash— Book weights and market weights Webster Company has compiled the
ID: 2790810 • Letter: W
Question
WACClong dash—Book
weights and market weightsWebster Company 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
$4,040,000
7%
Preferred stock
40,000
64,000
12%
Common stock equity
1,060,000
2,767,000
17%
Totals
$5,100,000
$6,871,000
.
a.Calculate the weighted average cost of capital using book value weights.
b. Calculate the weighted average cost of capital using market value
weights.
c. Compare the answers obtained in parts a and
b.Explain the differences.
Thank you!
Source of capital
Book value
Market value
After-tax cost
Long-term debt
$4,000,000
$4,040,000
7%
Preferred stock
40,000
64,000
12%
Common stock equity
1,060,000
2,767,000
17%
Totals
$5,100,000
$6,871,000
Explanation / Answer
Weighted average cost of capital (WACC) = wd*rd + we*re + wps*rps
where wd is weight of debt, rd is after tax cost of debt, we is weight of equity, re is after tax weight of equity, wps is weight of preferred stock and rps is after tax cost of preferred stock
rd = 7%
re = 12%
rps = 17%
a) In this we need to calculate WACC using book value weights
Book value of Long term debt = $4,000,000
Book value of preferred stock = $40,000
Book value of common stock equity = $1,060,000
wd = book value of long term debt / (book value of debt + book value of equity + book value of common stock equity)
= 4,000,000 / 5,100,000 = 0.78
we = book value of common stock equity / (book value of debt + book value of equity + book value of common stock equity) = 1,060,000 / 5,100,000 = 0.21
wps = book value of preferred stock / (book value of debt + book value of equity + book value of common stock equity) = 40,000 / 5,100,000 = 0.01
WACC = 0.78*7 + 0.21*17 + 0.01*12 = 9.12%
b) In this we need to calculate WACC using market value weights
Market value of Long term debt = $4,040,000
Market value of preferred stock = $64,000
Market value of common stock equity = $2,767,000
wd = market value of long term debt / (market value of debt + market value of equity + market value of common stock equity)
= 4,040,000 / 6,871,000 = 0.59
we = market value of common stock equity / (market value of debt + market value of equity + market value of common stock equity) = 2,767,000 / 6,871,000 = 0.40
wps = market value of preferred stock / (market value of debt + market value of equity + market value of common stock equity) = 64,000 / 6,871,000 = 0.01
WACC = 0.59*7 + 0.40*17 + 0.01*12 = 11.07%
c) WACC has increased by 11.07-9.12 = 1.96% when we calculate it by market value
If we see the after tax cost of common stock is equity is much more than after tax cost of long term debt. Share of market value of equity is almost doubled when we are calculating WACC by using market values. So the value of WACC has increased when we are calculating it by using market values instread of book values
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