Question

The president and CFO of Spellman Transportation are having a disagreement about whether to use market value or book value weights in calculating the WACC. Spellman's balance sheet shows a total of noncallable $45 million long-term debt with a coupon rate of 7.00% and a yield to maturity of 6.00%. This debt currently has a market value of $50 million. The company has 10 million shares of common stock, and the book value of the common equity (common stock plus retained earnings) is $65 million. The current stock price is $22.50 per share; stockholders' required return, r s, is 14.00%; and the firm's tax rate is 25%. The CFO thinks the WACC should be based on market value weights, but the president thinks book weights are more appropriate. What is the difference between these two WACCs? a. 1.42% b. 1.57% c. 2.16% d. 1.94% e. 1.75%

Answer 1

D57 x ✓ fc =E55-E43 C D E B 34 Book value WACC calculation: 35 Book value $ 65 Weights 0 .5909 Weighted cost (Cost %xWeights) 8.27% $ 45 0 .4091 1.84% Cost % 36 Equity | 14.00% 37 38 Debt (After tax cost) 4.50% 39 =6%*(1-25% 40 Total 42 43 $ 110 1.0000 WACC - Book value 10.11% 45 Market value WACC calculation: 46 47 Equity 48 Cost % 14.00% Market value $ 225 =10*22.5 Weights 0.8182 Weighted cost (Cost %xWeights) 11.45% 49 $ 50 0.1818 0.82% 50 Debt (After tax cost) L 4.50% =6%*(1-25%) 51 Total $ 275 1.0000 53 54 WACC -Market value 12.27% 57 Difference between WACC| 2.16%

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