Question

Compare Amazon Lite with Mutual Insurance using the following balance sheet information and calculate their WACC. Amazon Current Assets $2,000,000 Current Liabilities $1,000,000 Fixed Assets $7,000,000 Long-term Liabilities $5,000,000 Total Assets $9,000,000 Owners Equity $3,000,000 Mutual Insurance Bonds outstanding: 3,000 selling at $980 Common stock outstanding: 260,000 selling at $23.40 If the after-tax cost of debt is 8% for both companies and the cost of equity is 12% for Amazon and 13% for Mutual, which company has the highest WACC?

Answer 1

WACC calculations :

A) Amazon :

Equity = $30,00,000

Debt = $50,00,000

Total capital = Equity + Debt

Total capital = $30,00,000 + $50,00,000 = $80,00,000

Weight of debt = Debt / Total capital

Weight of debt = $50,00,000 / $80,00,000 = 0.625

Weight of equity = Equity / Total capital

Weight of equity = $30,00,000 / $80,00,000 = 0.375

After tax cost of debt = 8% or 0.08

Cost of equity = 12% or 0.12

Now,

WACC = (Weight of debt * Cost of debt after tax) + (Weight of equity * Cost of equity)

WACC = (0.625 * 0.08) + (0.375 * 0.12)

WACC = 0.05 + 0.045

WACC = 0.0950 or 9.50%

B) Mutual Insurance :

Debt = Bond price * No. Of outstanding bonds

Debt = $980 * 3,000 outstanding bonds

Debt = $29,40,000

Equity = Stock price * No. Of outstanding stock

Equity = $23.40 * 2,60,000 outstanding stock

Equity = $60,84,000

Total capital = Debt + Equity

Total capital = $29,40,000 + $60,84,000 = $90,24,000

Weight of debt = Debt / Total capital

Weight of debt = $29,40,000 / $90,24,000 = 0.326

Weight of equity = Equity / Total capital

Weight of equity = $60,84,000 / $90,24,000 = 0.674

Cost of debt after tax = 8% or 0.08

Cost of equity = 13% or 0.13

Now,

WACC = (Weight of debt * Cost of debt after tax) + (Weight of equity * Cost of equity)

WACC = (0.326 * 0.08) + (0.674 * 0.13)

WACC = 0.0261 + 0.0876

WACC = 0.1137 or 11.37%

Answer : Mutual insurance is having highest WACC @ 11.37% than Amazon's WACC @ 9.50%