WAcc-Book weights and market weights weester Company has compled the information

Question

WAcc-Book weights and market weights weester Company has compled the information shown in the ollowing table . Calculate the weighted average cost of captal using book value weights e. Compare tne answers obtained in parts a and b Explain the Sfarences a. The firms weighted average cost ofcapital usngtook value wegtsis?% (Round to two de mal places ? b. The trs weighted average cost of Capta, usng market value weight" D% Round to two de mal places ) e, Compare the answers otained in perts a andb Explain the ferences (Seect he best answer below OA The market alue approach yialds a higher cost of capital because the oosts of the components of the capital structure are calculated using the prevaling market prices Since the common stock is selling at a higher velue than its book value the cos he weighbed average cost of using market value weights of captal is much higher when using the market value wegh capnal s much lower when using tre maket value weigh The book value acoroad' yeas of capeal is much higher when using the book ae weignts ?C. righer cost of capta' because me costs of ne components ofthe caonai mactur aro caiaated using ??? prevaang market prices the common stock is seang af ? Ower vwue than ts market wave ne cost OD. The book alue approach yidsaloer cost of capital because the costs of the components of the captal structure are of captal is much higher when using the book alue weights Data Table Cick on the icon located on the top-right comner of the data table below in order t ts contents into a spreadsheet 5,000 3,244,000 5,100,000 7,339000 Click to select your answens Common stock equity 1060,000

Explanation / Answer

Solution: a. WACC using book values weights 8.90% Working Notes: Book value Long term debt 4,000,000   Preferred stock 40,000   Equity 1,060,000 Total 5,100,000 cost of debt after tax (kd) = 7% cost of preferred stock (Kp) = 11% cost of equity (ke) = 16% long term Debt weight in capital structure = D/V = book Value of debt / Total book Value of Company =4,000,000/5,100,000 =0.784313725 Preferred stock weight in capital structure = E/V =Book Value of Preferred stock / Total Book Value of Company =40,000/5,100,000 =0.007843137 Common stock weight in capital structure = E/V = Book Value of common stock / Total Book Value of Company =1,060,000/5,100,000 =0.207843137 WACC= Ke x E/V +Kp x P/V + Kd   x D/V E/V =   0.207843137          from above calculation D/V = 0.784313725 P/V=    0.007843137 WACC= Ke x E/V +Kp x P/V + Kd   x D/V = 16% x 0.207843137 + 11% x 0.007843137 + 7% x 0.784313725 =0.0890196 =0.0890 =8.90% b. WACC using market values weights 11.01% Working Notes: market value Long term debt 4,040,000   Preferred stock 55,000   Equity 3,244,000 Total 7,339,000 cost of debt after tax (kd) = 7% cost of preferred stock (Kp) = 11% cost of equity (ke) = 16% long term Debt weight in capital structure = D/V = market Value of debt / Total mkt Value of Company =4,040,000/7,339,000 =0.550483717 Preferred stock weight in capital structure = E/V =mkt Value of Preferred stock / Total mkt Value of Company =55,000/7,339,000 =0.007494209 Common stock weight in capital structure = E/V = mkt Value of common stock / Total mkt Value of Company =3,244,000/7,339,000 =0.442022074 WACC= Ke x E/V +Kp x P/V + Kd   x D/V E/V =   0.442022074          from above calculation D/V = 0.550483717 P/V=    0.007494209 WACC= Ke x E/V +Kp x P/V + Kd   x D/V = 16% x 0.442022074 + 11% x 0.007494209 + 7% x 0.550483717 =0.110081755 =0.1101 =11.01% c. Answer is a. The market value approach yields a higher cost of capital because the costs of the components of the capital structure are calculated using the prevailing market prices . Since the common stock is selling at a higher value than its book value , the cost of capital is much higher when using the market value weights. Working Notes: Book value WACC the cost of capital is 8.90% while Market value WACC is 11.01 % so, b cannot as b is say cost of capital is lower cost of capital , but as per our calculation market value approach have higher WACC Again , c is also wrong as book value approach has lower WACC. And , d is also wrong , as Book value approach uses , book value weight , not market value of the components. Please feel free to ask if anything about above solution in comment section of the question.

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