Question

WACC Book weights and market weights Webster Company has compiled the information shown in the following table:

source of capital. Book value Market value After-tax cost

Long-term debt $4,000,000 $3,840,000 6%

Preferred stock 40,000 60,000 13%

Common stock equity 1,060,000 3,000,000 17%

Totals $5,100,000. $6,900,000

.Calculate the weighted average cost of capital using book value weights

.b. Calculate the weighted average cost of capital using market value weights

.c. Compare the answers obtained in parts a and b Explain the differences.

Answer 1

Given -

Source of Capital	Book Value	Market Value	After Tax
Long Term Debt	4000000	3840000	6%
preferred Stock	40000	60000	13%
Common Stock Equity	1060000	3000000	17%

Total

5100000

6900000

Part a) Calculation of WACC using Book Value weight

  

WACC = We Ke + Wd Kd + Wp Kp

Where

We  = Weight of Equity = 1060000 / 5100000 = 0.2078

Wd    = Weight of Debt = 4000000 / 5100000 = 0.7843   

Wp = Weight of Preferred Stock = 40000 / 5100000 = 0.0078

Ke = 17%

Kd = 6%

Kp   = 13%

Now put all the values

WACC =  0.2078 * 17% + 0.7843 * 6% + 0.0078 * 13%

= 3.5326 + 4.7058 + 0.1014

WACC  = 8.339 %

Part b )

Calculation of WACC using Market Value weight

WACC = We Ke + Wd Kd + Wp Kp

Where

We  = Weight of Equity = 3000000 / 6900000 = 0.4347

Wd    = Weight of Debt = 3840000 / 6900000 = 0.5565

Wp = Weight of Preferred Stock = 60000 / 6900000 = 0.0086

Ke = 17%

Kd = 6%

Kp   = 13%

Now put all the values

WACC =  (0.4347 * 17) + (0.5565 * 6) + (0.0086 * 13)

= 7.3899 + 3.339 + 0.118

WACC = 10.846 %

Part c)

We can see the difference between WACC in above two scenarios. this is mainly due to change in the weights of different financing. if you try to analyze both the WACC you will find that during book value weight calculation the amout of debt is much more than amout of debt in Market value calculations, which is why the interest part in Book value debt will also be higher as a result it will get more tax rebate as interest is tax deductible. Other finding is that the equity component of book value WACC calculation is lower than equity component of Market value WACC calculations. By combining all this points we can conclude that the contribution of all the weights in WACC of  Book value calculations is less as compare to other.