Webster company has compiled the information shown in the following table. Sourc

Question

Webster company has compiled the information shown in the following table. Source of Capital Book Value Market Value After tax cost Long term debt $4,000,000 $3,840,000 6.0% Preferred stock 40,000 60,000 13.0 Common stock equity 1,060,000 3,000,000 17.0 TOTALS 5,100,000 6,900,000 A. Calculate the weighted average cost of capital using book value weights. B. Calculated the weighted average cost of capital using market value weights. C. Compare the answers obtained in parts A and B. Explain the differences.

Explanation / Answer

Weighted average cost of capital (WACC) is calculated by summing the proportions of each method of financing multiplied by its cost. WACC = (%debt * after tax cost of debt) + (%prefs * cost of prefs) + (%eq * cost of equity) I'm assuming that the book value and market value of the common and preferred stock are in $, not how many shares, this is important as it would change the answer markedly. The first step is to determine the weight of the components. The sum of the portfolio is the value of debt plus the value of common stock plus the value of preferred stock, this is given in the question in this instance. From there, we calculate the weight of each component. Book values Weight of debt = 4m/5.1m = 78.43% Weight of pref stock = 40000/5.1m= 0.7843% Weight of common stock = 1060000/5.1m = 20.78%, these should sum to 100% a) Book values = (78.43% * 6%) + (0.7843% * 13%) + (20.78% * 17%) = 8.34% b) market values Weight of debt = 3.84m/6.9m = 55.65% Weight of pref stock = 60000/6.9m= 0.8696% Weight of common stock = 3m/6.9m = 43.48%, these should sum to 100% = (55.65% * 6%) + (0.8696% * 13%) + (43.48% * 17%) = 10.84% c) The difference arises because the weighting of the methods of financing (debt, common stock etc) have changed and the more expensive method of financing, common stock, has a much larger market value than book value, pulling the overall WACC higher. Market value is likely to change on a daily basis whilst book value is static and is an accounting measure.

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