WACC–Book weights and market weights Webster Company has compiled the informatio

Question

WACC–Book weights and market weights Webster Company has compiled the information shown in the following table: Source of capital Book value Market value After-tax cost a. Calculate the weighted average cost of capital using book value weights. Long-term debt $4,000,000 $3,840,000 b. Calculate the weighted average cost of capital using market value weights. c. Compare the answers obtained in parts a and b. Explain the differences. Preferred stock 40,000 65,000 12% Common stock equity 1,060,000 4,632,000 16% Totals $5,100,000 $8,537,000 7%

Explanation / Answer

Book Value:

Weight of debt = 4,000,000/ 5,100,000 = 78.43%

Weight of Preferred Stock = 40,000/ 5,100,000 = 0.78%

Weight of Common Stock = 1,060,000/ 5,100,000 = 20.78%

WACC = 0.7843 * 7% + 0.0078 * 12% + 0.2078 * 16%

WACC = 5.49% + 0.09% + 3.33%

WACC = 8.91%

Market Value:

Weight of debt = 3,840,000/ 8,537,000 = 44.98%

Weight of Preferred Stock = 65,000/ 8,537,000 = 0.76%

Weight of Common Stock = 4,632,000/ 8,537,000 = 54.26%

WACC = 0.4498 * 7% + 0.0076 * 12% + 0.5426 * 16%

WACC = 3.15% + 0.09% + 8.68%

WACC = 11.92%

Part C

As we can see the difference in WACC because of market value and book value is 3.01%

It is always correct to take WACC based on amrket value as market value tells us the expectations of various investors about the capital structure of the firm.

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