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

1)	The first step is to calculate component cost of debt:
	Cost of debt:
	Before tax cost of debt is the YTM. Using an online
	calculator YTM = 7.94%
	After tax cost of debt = 7.94*(1-0.60) =	3.18%
	Cost of equity (Using constant dividend growth model)
	= 2.25*1.10/68.25+0.10 =	13.63%
	Cost of preferred capital =	11.00%
2)	WACC:
	Asset Class	Book Value		Market Value		Target Ratio
			BV Ratio		MV Ratio
	Long-term Debt	3,50,00,000	38.89%	3,34,00,000	36.15%	35%
	Preferred Stock	50,00,000	5.56%	70,00,000	7.58%	5%
	Stockholders’ Equity	5,00,00,000	55.56%	5,20,00,000	56.28%	60%
		9,00,00,000	100.00%	9,24,00,000	100.00%
	WACC with BV weights = 3.18*.3889+13.63*.5556+11*.0556 =	9.42
	WACC with MV weights = 3.18*.3615+13.63*.5628+11*.0758 =	9.65
	WACC with target ratio = 3.18*.35+13.63*.6+11*.05 =	9.84
3)	The WACC using target ratio is the most appropriate as it represents the planned capital structure of the firm. In such a case it would be inappropriate to use marginal WACC.
	The book value weights are historical and will not reflect the current market conditions.
	The market value weights are appropriate if there is no
	target capital structure.