Question

(Weighted average cost of capital—weights) A company has the following right-hand side of its balance sheet:
Bonds payable = $250,000

Preferred stock (1000 shares) = $100,000

Common stock (200,000 shares) = $400,000

--------------------------------------------------------------

Total Liabilities + Equity = $750,000
Bonds payable are currently priced at 115 (115% of face value) in the market, preferred stock is selling at $70 per share, and common stock is selling at $20 per share. Management has announced that it is targeting a capital structure composed of 65% debt and 35% equity. Of the equity, 10% is to be preferred stock, with the remainder common stock. Calculate the weights to be used in the weighted average cost of capital calculation if the weights are based on:

a. The company’s book values

b. The company’s market values

c. Management’s target capital structure

d. If management’s target weights were not known, which of the other two weighting schemes would you use? Why?

Answer 1

I have assumed the face value of 1 bond to be $ 1,000. This assumption is immaterial for the final answer. But we need this for intermediate calculation.

Please see the table below. Please be guided by the second row to understand the mathematics. The columns highlighted in yellow contain your answer. Figures in parenthesis, if any, mean negative values. All financials are in $.

Part (a), (b) and (c) have been answered in the table itself.

Source	Nos.	Book Value	Part (a) Weights based on company's book value	Market price	Market Value	Part (b) Weights based on company's market value	Part (c)
	N	Bi	Bi / Btotal	P	Vi = P x N	Vi / Vtotal
Bonds	250	250,000	33.33%	1,150	287,500	6.60%	65.00%
Preferred stock	1,000	100,000	13.33%	70	70,000	1.61%	3.50%
Common stock	200,000	400,000	53.33%	20	4,000,000	91.80%	31.50%
Total		750,000	100.00%		4,357,500	100.00%	100.00%

part (d)

If management’s target weights were not known, I will use the weights based on the market value.

WACC is required for estimating the market value of the firm. Hence, in order to maintain consistency, we must use the market value weighted cost of capital. Book values usually don't reflect the true intrinsic value of the different instruments of the firm. Hence, this is another reason for choice of market value based weights.