Question

Bolero, Inc., has compiled the following information on its financing costs: Type of Financing Book Value Market Value Cost Short-term debt $ 10,200,000 $ 11,200,000 4.3 % Long-term debt 3,200,000 3,200,000 7.4 Common stock 6,200,000 26,200,000 14.0 Total $ 19,600,000 $ 40,600,000 The company is in the 35 percent tax bracket and has a target debt–equity ratio of 65 percent. The target short-term debt/long-term debt ratio is 15 percent. a. What is the company’s weighted average cost of capital using book value weights? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Weighted average cost of capital % b. What is the company’s weighted average cost of capital using market value weights? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Weighted average cost of capital % c. What is the company’s weighted average cost of capital using target capital structure weights? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Weighted average cost of capital % d. Which is the correct WACC to use for project evaluation? Target weights Book weights Market weights

Answer 1

WACC = (w(STD) * k(STD) * (1 - Tax rate)) + (w(LTD) * k(LTD) * (1 - Tax rate)) + (w(CS) * k(CS))

where, STD = Short term debt, LTD = Long term debt and CS = Common Stock

k = cost of financing, k(STD) = 4.3%, k(LTD) = 7.4%, k(CS) = 14%

Tax rate = 35%

a. WACC using BV weights

w(STD) = 10.2/19.6 = 52.04%

w(LTD) = 3.2/19.6 = 16.33%

w(CS) = 6.2/19.6 = 31.63%

WACC(BV) = (0.5204 * 0.043 * (1 - 0.35)) + (0.1633 * 0.074 * (1 - 0.35)) + (0.3163 * 0.14)

= 0.0145 + 0.0079 + 0.0443

= 0.0667 = 6.67%

b. WACC using MV weights

w(STD) = 11.2/40.6 = 27.59%

w(LTD) = 3.2/40.6 = 7.88%

w(CS) = 26.2/40.6 = 64.53%

WACC(MV) = (0.2759 * 0.043 * (1 - 0.35)) + (0.0788 * 0.074 * (1 - 0.35)) + (0.6453 * 0.14)

= 0.0077 + 0.0038 + 0.0903

= 0.1018 = 10.18%

c. WACC using Target weights

Target Debt/Equity = 65% = 0.65/1

Therefore, Target Debt/Total Capital = Debt/(Debt + Equity) = 0.65/(0.65 + 1) = 0.3939 = 39.39%

Target Equity/Total Capital = 1 - 0.3939 = 0.6061 = 60.61%

Target STD/LTD = 15% = 0.15/1

Target STD/Total Debt = 0.15/(0.15 + 1) = 0.1304

Target LTD/Total Debt = 1 - 0.1304 = 0.8696

Therefore, STD/Total Capital = 0.1304 * 0.3939 = 0.0514

LTD/Total Capital = 0.8696 * 0.3939 = 0.3425

w(STD) = 5.14%

w(LTD) = 34.25%

w(CS) = 60.61%

WACC(Target) = (0.0514 * 0.043 * (1 - 0.35)) + (0.3425 * 0.074 * (1 - 0.35)) + (0.6061 * 0.14)

= 0.0014 + 0.0165 + 0.0849

= 0.1028 = 10.28%

d. WACC determined by using MV weights is the correct one to use for evaluation.