Question

The president and CFO of Spellman Transportation are having a disagreement about whether to use market value or book value weights in calculating the WACC. Spellman'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 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 $22.50 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?

a) 1.55%

b) 1.72%

c) 1.91%

d) 2.13%

1!

I know the answer is 2.13%, but a detailed answer showing how you got to this solution would be extremely helpful. Thanks!

Answer 1

	Book	Book %	Market	Market %
Debt	45	41%	50	18%
Equity	65	59%	225	82%
Total	110		275

Calculate the book and market values of both debt and equity as shown above.

Compute their weights accordingly.

WACC = wd x rd x (1 - tax) + ws x rs, where w - weights and r - cost

With book values, WACC = 41% x 7% x (1 - 40%) + 59% x 14% = 9.99%

With market values, WACC = 18% x 6% x (1 - 40%) + 82% x 14% = 12.11%

Difference = 2.12%

Hence, d appears to be correct.