Chapter 18, Problem 9QP

WACC Bolero, Inc., has compiled the following information on its financing costs:

The company is in the 35 percent tax bracket and has a target debt-equity ratio of 60 percent. The target short-term debt/long-term debt ratio is 20 percent.

1. a. What is the company’s weighted average cost of capital using book value weights?
2. b. What is the company’s weighted average cost of capital using market value weights?
3. c. What is the company's weighted average cost of capital using target capital structure weights?
4. d. What is the difference between WACCs? Which is the correct WACC to use for project evaluation?

Summary Introduction

To determine: The Company’s Weighted Average Cost of Capital using Book Value Weights.

Introduction: Beta is the risk related with a portfolio or a security in connection to the market. It is also termed as the beta coefficient; it is a method for deciding on the requirement on security or stock that may move in contrast with the market. Leverage is a method that increases profits or losses of the shareholders. It is usually used to illustrate the utilization of funds borrowed to increase income prospective or financial leverage. However it can also explain the use of fixed assets to accomplish the similar objectives.

Answer to Problem 9QP

The Company’s Weighted Average Cost of Capital using Book Value Weights is 6.09%.

Explanation of Solution

Determine the Weight of Short-Term Debt

$\begin{array}{c}WeightofShortTermDebt=\left[\frac{BookValueofShortTermDebt}{TotalBookValue}\right]\\ =\left[\frac{\$12,000,000}{\$41,000,000}\right]\\ =0.292683or0.2927\end{array}$

Therefore the Weight of Short-Term Debt is 0.2927

Determine the Weight of Long-Term Debt

$\begin{array}{c}WeightofLongTermDebt=\left[\frac{BookValueofLongTermDebt}{TotalBookValue}\right]\\ =\left[\frac{\$20,000,000}{\$41,000,000}\right]\\ =0.487805or0.4878\end{array}$

Therefore the Weight of Long-Term Debt is 0.4878

Determine the Weight of Equity

$\begin{array}{c}WeightofEquity=\left[\frac{BookValueofEquity}{TotalBookValue}\right]\\ =\left[\frac{\$9,000,000}{\$41,000,000}\right]\\ =0.219512or0.2195\end{array}$

Therefore the Weight of Equity is 0.2195

Determine the Weighted Average Cost of Capital using Book Value Weights

$\begin{array}{c}WACC=\left[\begin{array}{l}\left(\begin{array}{l}\left(Weigh{t}_{Equity}\times Rat{e}_{Equity}\right)\times \\ \left(1-Tax\right)\end{array}\right)+\left(\begin{array}{l}\left(Weigh{t}_{Debt}\times Rat{e}_{Debt}\right)\times \\ \left(1-Tax\right)\end{array}\right)+\\ \left(Weigh{t}_{CommonStock}\times Rat{e}_{CommonStock}\right)\end{array}\right]\\ =\left[\begin{array}{l}\left(\begin{array}{l}\left(0.4878\times 7.20\%\right)\times \\ \left(1-35\%\right)\end{array}\right)+\left(\begin{array}{l}\left(0.2927\times 4.10\%\right)\times \\ \left(1-35\%\right)\end{array}\right)+\\ \left(0.2195\times 13.80\%\right)\end{array}\right]\\ =\left[0.0078+0.022829+0.030293\right]\\ =0.060922or6.09\%\end{array}$

Therefore the Weighted Average Cost of Capital using Book Value Weights is 6.09%

Summary Introduction

To determine: The Company’s Weighted Average Cost of Capital using Market Value Weights.

Answer to Problem 9QP

The Company’s Weighted Average Cost of Capital using Market Value Weights is 9.90%.

Explanation of Solution

Determine the Weight of Short-Term Debt

$\begin{array}{c}WeightofShortTermDebt=\left[\frac{MarketValueofShortTermDebt}{TotalMarketValue}\right]\\ =\left[\frac{\$12,500,000}{\$89,500,000}\right]\\ =0.139665or0.1397\end{array}$

Therefore the Weight of Short-Term Debt is 0.1397

Determine the Weight of Long-Term Debt

$\begin{array}{c}WeightofLongTermDebt=\left[\frac{MarketValueofLongTermDebt}{TotalMarketValue}\right]\\ =\left[\frac{\$23,000,000}{\$89,500,000}\right]\\ =0.256983or0.2570\end{array}$

Therefore the Weight of Long-Term Debt is 0.2570

Determine the Weight of Equity

$\begin{array}{c}WeightofEquity=\left[\frac{MarketValueofEquity}{TotalMarketValue}\right]\\ =\left[\frac{\$54,000,000}{\$89,500,000}\right]\\ =0.603352or0.6034\end{array}$

Therefore the Weight of Equity is 0.6034

Determine the Weighted Average Cost of Capital using Market Value Weights

$\begin{array}{c}WACC=\left[\begin{array}{l}\left(\begin{array}{l}\left(Weigh{t}_{Equity}\times Rat{e}_{Equity}\right)\times \\ \left(1-Tax\right)\end{array}\right)+\left(\begin{array}{l}\left(Weigh{t}_{Debt}\times Rat{e}_{Debt}\right)\times \\ \left(1-Tax\right)\end{array}\right)+\\ \left(Weigh{t}_{CommonStock}\times Rat{e}_{CommonStock}\right)\end{array}\right]\\ =\left[\begin{array}{l}\left(\begin{array}{l}\left(0.2570\times 7.20\%\right)\times \\ \left(1-35\%\right)\end{array}\right)+\left(\begin{array}{l}\left(0.1397\times 4.10\%\right)\times \\ \left(1-35\%\right)\end{array}\right)+\\ \left(0.6034\times 13.80\%\right)\end{array}\right]\\ =\left[0.003722+0.012027+0.083263\right]\\ =0.099011or9.90\%\end{array}$

Therefore the Weighted Average Cost of Capital using Market Value Weights is 9.90%

Summary Introduction

To determine: The Company’s Weighted Average Cost of Capital using Target Capital Structure Weights.

Answer to Problem 9QP

The Company’s Weighted Average Cost of Capital using Target Capital Structure Weights is 10.25%.

Explanation of Solution

Determine the Value of Debt

$\begin{array}{c}ValueofDebt=\left[\frac{T\arg etDebtEquityRatio}{1+T\arg etDebtEquityRatio}\right]\\ =\left[\frac{60\%}{1+60\%}\right]\\ =0.375or37.5\%\end{array}$

Therefore the Value of Debt is 37.5%

Determine the Value of Equity

$\begin{array}{c}ValueofEquity=\left[1-ValueofDebt\right]\\ =\left[1-37.5\%\right]\\ =0.625or62.5\%\end{array}$

Therefore the Value of Equity is 62.5%

Determine the Weight of Short-Term Debt of Total Debt

$\begin{array}{c}WeightofShortTermDebt=\left[\frac{T\arg etShort/LongTermDebtRatio}{1+T\arg etShort/LongTermDebtRatio}\right]\\ =\left[\frac{20\%}{1+20\%}\right]\\ =0.166667or0.1667\end{array}$

Therefore the Weight of Short-Term Debt of Total Debt is 0.1667

Determine the Weight of Long-Term Debt of Total Debt

$\begin{array}{c}WeightofLongTermDebt=\left[1-WeightofShortTermDebt\right]\\ =\left[1-0.166667\right]\\ =0.833333or0.8333\end{array}$

Therefore the Weight of Long -Term Debt of Total Debt is 0.8333

Determine the Weight of Short-Term Debt

$\begin{array}{c}WeightofShortTermDebt=\left[ValueofDebt\times WeightofShortTermDebt\right]\\ =\left[37.5\%\times 0.1667\right]\\ =0.0625or6.25\%\end{array}$

Therefore the Weight of Short-Term Debt is 6.25%

Determine the Weight of Long-Term Debt

$\begin{array}{c}WeightofLongTermDebt=\left[ValueofEquity\times WeightofLongTermDebt\right]\\ =\left[62.5\%\times 0.8333\right]\\ =0.3125or31.25\%\end{array}$

Therefore the Weight of Long-Term Debt is 31.25%

Determine the Weighted Average Cost of Capital using Target Capital Structure Weights:

$\begin{array}{c}WACC=\left[\begin{array}{l}\left(\begin{array}{l}\left(Weigh{t}_{Equity}\times Rat{e}_{Equity}\right)\times \\ \left(1-Tax\right)\end{array}\right)+\left(\begin{array}{l}\left(Weigh{t}_{Debt}\times Rat{e}_{Debt}\right)\times \\ \left(1-Tax\right)\end{array}\right)+\\ \left(Weigh{t}_{CommonStock}\times Rat{e}_{CommonStock}\right)\end{array}\right]\\ =\left[\begin{array}{l}\left(\begin{array}{l}\left(0.3125\times 7.20\%\right)\times \\ \left(1-35\%\right)\end{array}\right)+\left(\begin{array}{l}\left(0.0625\times 4.10\%\right)\times \\ \left(1-35\%\right)\end{array}\right)+\\ \left(0.625\times 13.80\%\right)\end{array}\right]\\ =\left[0.014625+0.001666+0.08625\right]\\ =0.102541or10.25\%\end{array}$

Therefore the Weighted Average Cost of Capital using Target Capital Structure Weights is 10.25%

Summary Introduction

To determine: The Difference between WACC and the appropriate WACC to use for project evaluation.

Explanation of Solution

The difference between WACC and the appropriate WACC to use for project evaluation is as follows:

The difference in WACC between the three weights is based on the diverse weights. The WACC of the company is equally look like the WACC estimated by using target weights as the project will be financed under the target ratio. Hence, the WACC calculated using target weights should be considered for project evaluation.