Question

capital structure. How signal 13 C UMUT 6. A relatively young firm has capital components valued at book and market and market component costs as follows. No new securities have been issued since the firm was originally capitalized. Value Component Market Book Cost Debt $42,830 $40,000 8.5% Preferred stock 10,650 10,000 10.6 Common equity 65,740 32,000 25.3 a. Calculate the firm's capital structures and WACCs based on both book and market values, ar compare the two b. What appears to have happened to interest rates since the company was started? c. Does the firm seem to be successful? Why? d. What would be the implication of using a WACC based on book as opposed to m In other words, what kinds of mistakes might management make by using the boor 7 Five years ago Heminawa... as opposed to market values? e by using the book values? coup

Answer 1

a.

market value
Particulars	Cost	Market value	weights= market value / total	WACC= cost * weights
Bonds	8.50%	42,830.00	0.36	8.50%*0.36	0.0305
Preferred stock	10.60%	10,650.00	0.09	10.60%*0.09	0.0095
Equity	25.30%	65,740.00	0.55	25.30%*.55	0.1395
Total		119,220.00			0.1795

So here to calculate the WACC we need to find the weights first.

Weight = market value / total

And WACC= cost * weights

According to market value the WACC is 17.95%

Similarly,

Book value
Particulars	Cost	Market value	weights= market value / total	after tax cost * weights
Bonds	8.50%	40,000.00	0.49	8.50%*0.49	0.0415
Preferred stock	10.60%	10,000.00	0.12	10.60%*0.12	0.0129
Equity	25.30%	32,000.00	0.39	25.30%*0.39	0.0987
Total		82,000.00			0.1531

According to Book value, WACC is 15.31%

b. the interest rates have increased since the firm started and that has happened majorly because the value of equity shares has increased from $32000 to $65740 and this has lead to overall increase In the WACC

c.

yes the firm is successful, as the market value of equity has increased which shows profits of the firm

d.

Market value id preferred over book value because:

1. The WACC is used to estimate the value of the firm and it should be based on the latest data and that is possible in market value approach
2. Book value method can be used only for short term and not in long future to use it for financing decisions, as it will not be accurate and will not help in estimating the present scenario, because of the historical numbers and not present values.