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

Wacc according to market value weights:

Wacc=cost of debt after tax*proportion of debt in total capital+cost of common stock*proportion of common stock in total capital

Cost of debt after tax=Coupon rate(1-tax rate) =0.07(1-.40)=0.042 or 4.2%

Proportion of debt in total capital(acc. To market value)=market value of debt/market value of debt+market value of common stock=$50million/{$50million+(10millionshares*$27.50)}=$50million/$325million=15.39%

Cost of common stock=required rate of return=14%

Proportion of common stock in total capital (acc. To market value method)=$275 million/$325 million=84.61%

Wacc=(4.2%*.1539)+(14%*.8461%)=.64638+11.84=12.49%

Similarly,wacc(acc.to book value weights)=4.2%*($45million/$45million+$65million)+14%*($65million/$45million+$65million)

(4.2%*.4090)+(14%*.5910)=1.7178+8.274=9.9918%or 10%

So,difference between both wacc is=12.49%-10%=2.49%