Question

Sapp Trucking’s balance sheet shows a total of $45 million debt with a coupon rate of 7% and a yield to maturity of 6%. This debt currently has a market value of $50 million. The balance sheet also shows that the company has 10 million shares of common stock, and the book value of the common equity is $65 million. The current stock price is $22.50 per share; stockholders’ required return is 14% and the firm’s tax rate is 40%. Your believe the WACC should be based on the market value weights, but your manager thinks book weights are more appropriate. (a) Calculate the WACC using market value and book value weights. (b) How can you convince your manager to use market value weights instead of book value weights?

Answer 1

(a) Calculation of WACC using Book value weights

Particulars	Weight	Cost of capital	WACC
Debt	0.41	3.6 %	1.476 %
Equity	0.59	14%	8.27 %
Total WACC	1	17.6	9.746 %

Kd or cost of debt

Total debt is $45 million and Total equity is $65 million = $110 million

Weight of debt = $45 million / $110 million

= 0.41

Yield to maturity is 6 %, after tax cost will be 6% (1-0.40) = 3.6%

Ke or Cost of equity

Total equity is $65 million

Weight = $65 million / $110 million

= 0.59

Cost of equity is 14%

Net WACC = 9.746 %

Calculation of WACC using market value weights

Particulars	Weight	Cost of capital	WACC
Debt	0.18	3.6 %	0.648 %
Equity	0.82	14%	11.48 %
Total WACC	1	17.6	12.128 %

Kd or cost of debt

Total debt is $50 million and Total equity is $225 million ($22.5 * 10 million shares) = $275 million

Weight of debt = $50 million / $275 million

= 0.18

Yield to maturity is 6 %, after tax cost will be 6% (1-0.40) = 3.6%

Ke or Cost of equity

Total equity is $225 million

Weight = $225 million / $275 million

= 0.82

Cost of equity is 14%

Net WACC = 12.128 %

(b) As can be suggested from the above calculation, the cost of capital is higher for the company because WACC is 12.12% using market value, while it is just 9.7% using book value. therefore, more realistic number can be achieved in terms of cost of capital that the company is incurring. Market value weights are considered more appropriate because investors who invest his capital in company would want market required return and not return which is based on book values. The investor invest capital which is based on the market and hence return expected by him is also based on the prevailing rate of return in the market. Thus, it is important to consider market value weights instead of book value for the purpose of calculating WACC.