Westerly Manufacturing has compiled the information shown in the following table
ID: 2706751 • Letter: W
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
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
Westerly Manufacturing has compiled the information shown in the following table: Calculate the firm's weighted average cost of capital (WACC) using book value weights. Calculate the firm's weighted average cost of capital (WACC) using market value weights. 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
Hi,
Please find the answer as follows:
Part A:
WACC (Book Value Weights) = After Cost of Debt*Weight of Debt + Cost of Preferred Stock*Weight of Preferred Stock + Cost of Equity*Weight of Equity
WACC (Book Value Weights) = 6*4000000/5100000 + 13*40000/5100000 + 17*1060000/5100000 = 8.34%
Part B:
WACC (Market Value Weights) = 6*3840000/6900000 + 13*60000/6900000 + 17*3000000/6900000 = 10.84%
Part C:
The difference is on account of the proportion of different instruments in the capital structure. The market value of equity is high as compared to the book value and this is one of the reasons for difference in WACC.
Market value is a more accurate measure as it reflects the current value of company's financial instruments while book values remain static and fail to represent the current position of the company's capital structure.
Thanks.
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