Westerly Manufacturing has compiled the information shown in the following table

Question

Westerly Manufacturing 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 firm%u2019s weighted average cost of capital (WACC) using book value weights.

(b)          Calculate the firm%u2019s weighted average cost of capital (WACC) using market value weights.

(c)           Compare your answers found in parts (a) and (b) and briefly explain the differences. Other things equal, would you recommend that Westerly Manufacturing rely on its book value weights or market value weights in determining its WACC?

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 stockare 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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