Question

The following information is for DEF, Inc. a national consumer products company:

Liabilities and Equity	Book values	Target Capital Structure
Notes Payable	$200	3%
Long-term Debt	1,000	15%
Preferred Stock	500	5%
Common equity	4,200	77%

Assume that you are an analyst preparing to calculate DEF’s WACC and that the company’s target capital structure values above are unknown to you. Further, assume that DEF’s cost of debt and cost of equity values are significantly different from each other. How will your estimate of WACC be affected by using weights calculated from the known book values rather than the unknown target capital structure in your calculations?

Answer 1

Solution :- Calculation of weighted average cost of capital (WACC) using the book value weights as base :-

Particulars	Book value	Book value weights
Long term debt	1000	0.17 (1000 / 5700)
Preferred stock	500	0.09 ( 500 / 5700)
Common equity	4200	0.74 (4200 / 5700)
Total	5700	1

The book value weights for Long term debt, Preferred stock and common equity will be 0.17, 0.09 and 0.74 respectively. Afterward, The following formula will be applied for WACC calculation :-

WACC (using book value weights) = Weight of long term debt * Cost of long term debt (after tax) + Weight of preferred stock * Cost of preferred stock + Weight of common equity * Cost of common equity.

(Note :- Notes payable, being liability only and not the part of capital structure of firm, accordingly, will not be included in the calculation of weighted average cost of capital).