Question

Sapp Trucking's balance sheet shows a total of noncallable $45 million long-term debt with a coupon rate of 7.00% and a yield to maturity of 6.00%. This debt currently has a market value of $50 million. The balance sheet also shows that the company has 10 million shares of common stock, and the book value of the common equity (common stock plus retained earnings) is $65 million. The current stock price is $27.50 per share; stockholders' required return, rs, is 14.00%; and the firm's tax rate is 40%. 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

Market value of Debt = $50 million

Market value of equity = $27.50 * 10 million shares =$275 million

Total market value = $275 + $50 = $325 million

Weight of Market value of debt = $50/$325 *100 = 15.38%

Weight of Market value of Equity= $275/$325 *100 = 84.62%

Book value of Debt = $45 million

Book value of Equity = $65 million

Total Book value = $45 + $65 = $110 million

Weight of Book value of debt = $45/$110 *100 = 40.91%

Weight of Book value of Equity= $65/$110 *100 = 59.09%

WACC= WdRd(1-t) + We*Re

Bond yield (rd) = 6%

tax rate = 40 %

Cost of equity (re) = 14%

WACC at Market value = .1538*6(1-.40)+.8462*14 = 12.40%

WACC at Book value = .4091*6(1-.40)+.5909*14 = 9.75%

Difference between these two WACCs = 12.40% - 9.75% = 2.65%