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

  

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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