Question

Williams, Inc., has compiled the following information on its financing costs:

  

Type of Financing	Book Value			Market Value			Cost
Short-term debt	$	14,600,000		$	13,800,000		4.0	%
Long-term debt		39,500,000			34,700,000		7.1
Common stock		11,600,000			93,000,000		12.9
Total	$	65,700,000		$	141,500,000

  

The company is in the 23 percent tax bracket and has a target debt-equity ratio of 60 percent. The target short-term debt/long-term debt ratio is 20 percent.

  

a.	What is the company’s weighted average cost of capital using book value weights?

d.	Which is the correct WACC to use for project evaluation?

    

• Target weights

• Book weights

• Market weights

Answer 1

Question a:

Short term debt cost = rs = 4%

Long term debt cost = rl = 7.1%

Common stock = re = 12.9%

tax rate = t = 23%

>>>>>>>

Value of Short term debt = $14,600,000

Value of Long term debt = $39,500,000

Value of Common stock = $11,600,000

Total Value = $65,700,000

>>>>

Weight of Short term debt = Ws =Value of short term debt / Total Value = $14,600,000 / $65,700,000 = 0.2222

Weight of Long term debt = Wl = Value of Long term debt / Total Value = $39,500,000 / $65,700,000 = 0.6012

Weight of Common stock = Wc = Value of common stock / Total Value = $11,600,000 / $65,700,000 = 0.1766

>>>>

Weighted Average cost of capital = [Ws * rs * (1-t)] + [Wl * rl * (1-t)] + [Wc * re]

= [0.2222 * 4% * (1-25%)] + [0.6012 * 7.1% * (1-25%)] + [0.1766 * 12.9%]

= 0.6666% + 3.20139% + 2.27814%

= 6.14613%

Weighted Average cost of capital with book value weights is 6.15%

>>>>>>>

Value of Short term debt = $13,800,000

Value of Long term debt = $34,700,000

Value of Common stock = $93,000,000

Total Value = $141,500,000

>>>>

Weight of Short term debt = Ws =Value of short term debt / Total Value = $13,800,000 / $141,500,000 = 0.0975

Weight of Long term debt = Wl = Value of Long term debt / Total Value = $34,700,000 / $141,500,000 = 0.2452

Weight of Common stock = Wc = Value of common stock / Total Value = $93,000,000 / $141,500,000 = 0.6573

>>>>

Weighted Average cost of capital = [Ws * rs * (1-t)] + [Wl * rl * (1-t)] + [Wc * re]

= [0.0975 * 4% * (1-25%)] + [0.2452 * 7.1% * (1-25%)] + [0.6573 * 12.9%]

= 0.2925% + 1.30569% + 8.47917%

= 10.07736%

Weighted Average cost of capital with market value weights is 10.08%

>>>>>>>

Short term / Long term = 20% = 0.2 /1

short term = 0.2 / 1.2 = 0.166667

Long term = 1/1.2 = 0.833333

>>>>

Debt Equity ratio = 60%

(Long term + Short term debt ) / Equity = 0.6/1

Weight of Long term + short term debt = 0.6/1.6 = 0.375

Weight of Equity =We= 1/1.6 = 0.625

Weight of Short term debt =Ws = 0.375 * 0.166667 = 0.0625

Weight of Long term debt = Wl = 0.375 * 0.833333 = 0.3125

>>>>

Weighted Average cost of capital = [Ws * rs * (1-t)] + [Wl * rl * (1-t)] + [Wc * re]

= [0.0625 * 4% * (1-25%)] + [0.3125 * 7.1% * (1-25%)] + [0.625 * 12.9%]

= 0.1875% + 1.66406% + 8.0625%

= 9.91406%

Weighted Average cost of capital with target weights is 9.91%

Question b:

Correct WACC to use for project evaluation is Target weights weighted average cost of capital