Question

​(Weighted average cost of capital​) Crawford Enterprises is a publicly held company located in​ Arnold, Kansas. The firm began as a small tool and die shop but grew over its​ 35-year life to become a leading supplier of metal fabrication equipment used in the farm tractor industry. At the close of​ 2015, the​firm's balance sheet appeared as​ follows:

Cash: 450,000
Accounts receivable: 4,250,000
Inventories: 8,400,000
Net property, plant, and equipment: 17,821,000
Total assets: 30,921,000

Long-term debt: 11,800,000
Common equity: 19,121,000
Total debt and equity: 30,921,000

.

At present the​ firm's common stock is selling for a price equal to its book​ value, and the​ firm's bonds are selling at par.​ Crawford's managers estimate that the market requires a return of 18 percent on its common​ stock, the​ firm's bonds command a yield to maturity of 8 ​percent, and the firm faces a tax rate of 38 percent.

a. What is​ Crawford's weighted average cost of​ capital?

b. If​ Crawford's stock price were to rise such that it sold at 1.5 times book​ value, causing the cost of equity to fall to 16 ​percent, what would the​ firm's cost of capital be​ (assuming the cost of debt and tax rate do not​ change)?

Answer 1

Weighted average cost of capital is the cost of capital calculated based on weight of debt and equity in the balance sheet.
a.
Calculation of weight of capital
	Amount	Weights
Debt	$11,800,000	38.16%	11800000/30921000
Equity	$19,121,000	61.84%	19121000/30921000
	$30,921,000
Calculation of after tax cost of debt
After tax cost of debt	8*(1-0.38)
After tax cost of debt	4.96%
Calculation of weighted average cost of capital
	Weights	Cost of capital	Weighted average (Weights*Cost of capital)
Debt	38.16%	4.96%	1.89%
Equity	61.84%	18%	11.13%
Thus, weighted average cost of capital is 13.02%			13.02%
b.
Calculation of weight of capital
	Amount	Weights
Debt	$11,800,000	29.15%	11800000/40481500
Equity (19121000*1.5)	$28,681,500	70.85%	28681500/40481500
	$40,481,500
Calculation of weighted average cost of capital
	Weights	Cost of capital	Weighted average (Weights*Cost of capital)
Debt	29.15%	4.96%	1.45%
Equity	70.85%	16%	11.34%
			12.78%
Thus, weighted average cost of capital is 12.78%