Question

Computerized Business Systems (CBS) transforms manual accounting and inventory systems into computerized, more efficient, systems. Many of their customers describe the transition as an overnight evolution from the dark ages to the 21st century. Manual systems are far too cumbersome with respects to both time and inventory control.  

Vicky Pagel has been a financial analyst with CBS for over five years. Although she normally does not get involved with sales, her most recent assignment was to assist Jack Ingram, a new sales representative. Jack is in the process of trying to sell a CBS system to Corbin Mills, a firm that does not know how to determine accurately its weighted average cost of capital (WACC). Corbin Mills, therefore, cannot determine whether the net present value (NPV) of the CBS system is positive or negative.

To calculate Corbin Mills' WACC, Vicky first needed to gather information on the firm's cost of raising funds from various sources. As she proceeded with the analysis, she learned that Corbin Mills could issue 20-year corporate bonds at a coupon rate of 9%. As a result of current interest rates, the bonds could be sold for $1,105 each. These bonds pay interest annually, and have a par value of $1,000. A corporate tax rate of 40% applies.  

Corbin Mills can raise additional funds through a new issues of common stock. Their common stock is currently selling for $68.25 per share. The most recent dividend paid was in the amount of $2.25. Corbin's dividends have previously grown at a rate of 4%, but this growth rate is expected to jump to 10% the year after and continue at this rate to infinity.

A final source from which funds could be raised is via preferred stock. $100-par preferred stock can be issued at an 11% annual dividend rate. The preferred shares currently trade at $100 per share.

Put yourself in Vicky Pagel's position, and develop the WACC calculation that will be used in evaluating projects for Corbin Mills.

The following table contains the market and book values of each asset class.

Asset Class	Book Value	Market Value	Target Ratio
Long-term Debt	$35,000,000	$33,400,000	35%
Preferred Stock	$5,000,000	$7,000,000	5%
Stockholders’ Equity	$50,000,000	$52,000,000	60%

Please calculate the WACC, of the three “weights (book value, market value, target ratio) which one is the most appropriate to use?  Why?

Answer 1

Cost of debt: 20 year corporate bond can be issued at 9% and its market price is expected to be $1105 on a par value of $1000. The current yield to maturity (YTM) should be the cost of debt. Lets denote YTM as r, then the r which will equate the future cash flows (coupon of $90 annually and $1000 after 20 years) to current market price is the YTM.

1105 = 90/(1+r) + 90/(1+r)² + .... + (90+1000)/(1+r)²⁰ - solving for r, we get r = 7.94%

Hence Cost of debt (R_debt) = 7.94% * (1-40%) = 4.76%

Cost of preferred stock (R_Pref) : Current dividend yield is the cost of preferrred stock which in this case is 11% since the market price and issue price is same.

Cost of equity (R_equity): we will use the dividend discount model which states that the current market price is the present value of future dividends and discount rate used is cost of equity (r).

Current dividend = $ 2.25

Next Year dividend = 2.25 * (1+4%) = $2.34

Temrinal equity value till perpetuity at 10% growth rate which is applicable from year after = 2.34 (r-10%)

The present value of these cash flows discounted at r should equal current price of 68.25. Hence

68.25 = 2.25 + 2.34/(1+r) + [2.34/(r-10%)]/(1+r)² ; solving for r , we get r = 12.87% which is the cost of equity.

Now we can calculate WACC as below:

WACC = weight of debt * cost of debt + weight of pref stock * cost of pref stock + weight of equity * cost of equity

Book Value Weights WACC = (35/90) * 4.76% + (5/90) * 11% + (50/90) * 12.87% = 9.61%

Market Value Weights WACC = (33.4/92.4) * 4.76% + (7/92.4) * 11% + (52/92.4) * 12.87% = 9.80%

Target Ratio WACC = 35% * 4.76% + 5% * 11% + 60% * 12.87% = 9.94%

Between the book value, market value and target ratio, book value weights are easier to calculate since they would be available from the financial statements but market value is superior since it will reflect not the historical balance sheet cost of resources but the current market valuation basis the company (& economy's in general) current and future prospects. Target ratio can be starting point when business commences or for periodic restructuring but it is difficult to practically keep adjusting the weights every time the values change, hence market vaue WACC should be the most appropriate