Question

Zagrot Trucking’s balance sheet shows a total of noncallable $45 million long-term debt with a coupon rate of 8.00% and a yield to maturity of 6.00%. This debt currently has a market value of $100 million. The balance sheet also shows that the company has 20 million shares of common stock, and the book value of the common equity (common stock plus retained earnings) is $650 million. The current stock price is $100 per share; stockholders' required return, rs, is 13.00%; and the firm's tax rate is 21%. The CFO thinks the WACC should be based on market value weights, but the president thinks book weights are more appropriate. What is the difference between these two WACCs?

Answer 1

WACC based on book value:

Book value of debt = 45,000,000

Book value of equity = 20,000,000 * 650 = 13,000,000,000

Total book value = 45,000,000 + 13,000,000,000 = 13,045,000,000

Weight of debt = 45,000,000 / 13,045,000,000 = 0.00345

Weight of equity = 13,000,000,000 / 13,045,000,000 = 0.99655

Pre tax cost of debt = 6%

After tax cost of debt = 0.06 ( 1 - 0.21)

After tax cost of debt = 0.0474 or 4.74%

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

WACC = 0.99655 * 0.13 + 0.00345 * 0.0474

WACC = 0.129552 + 0.000164

WACC using book value = 0.129716 or 12.9716%

WACC based on market value:

Market value of debt = 100,000,000

Market value of equity = 20,000,000 * 100 = 2,000,000,000

Total Market value = 100,000,000 + 2,000,000,000 = 2,100,000,000

Weight of debt = 100,000,000 / 2,100,000,000 = 0.047619

Weight of equity = 2,000,000,000/ 2,100,000,000 = 0.952381

Pre tax cost of debt = 6%

After tax cost of debt = 0.06 ( 1 - 0.21)

After tax cost of debt = 0.0474 or 4.74%

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

WACC = 0.952381 * 0.13 + 0.047619 * 0.0474

WACC = 0.12381 + 0.002257

WACC using market value = 0.126067 or 12.6067%

Difference between the two = 12.9716% - 12.6067% = 0.3649%

Market Value WACC is considered appropriate by analysts because an investor would demand market required rate of return on the market value of the capital and not the book value of the capital.