Question

A summary of the balance sheet of Travellers Inn Inc. (TII), a company that was formed by merging a number of regional motel chains and that hopes to rival Holiday Inn on the North American scene, is shown below: Travellers Inn: December 31, 2015 (Millions of Dollars) Cash $10 Accounts payable $10 Accounts receivable 20 Accruals 10 Inventories 20 Short-term debt 5 Current assets 50 Current liabilities 25 Net fixed assets 38 Long-term debt 20 Preferred stock 3 Common equity Common stock 10 Retained earnings 30 Total common equity $40 Total assets $88 Total liabilities and equity $88 These facts are also given for TII: (1) Short-term debt consists of bank loans that currently cost 10%, with interest payable quarterly. These loans are used to finance receivables and inventories on a seasonal basis, so in the off-season, bank loans are zero.

Answer 1

Weighted Average Cost of Capital (“WACC”)
is the ‘average of the cost’ of these sources of capital WACC is the minimum return that a company must earn on its existing capital to satisfy the respective stakeholder like shareholders, creditors, lenders etc. Mathematically, it is weighted average of the costs of each of the different types of capital which can be shown as the following equation:

Where:
E = Market value of equity
D = Market value of debt
P = Market value of preferred stock
V = E + D + P
Ke = Cost of equity
Kd = Cost of debt
Kp = Cost of preferred stock
t = tax rate

Calculation of WACC at Book Value:

Total Value of the capital(V) =  Debt + Preferred Stock + Common Stock

= $ 20 + $ 3 + $10 = $ 33 million

  
Cost of equity (Ke) = Rf + β × (Rm − Rf)

= 5% + 1.7 ( 8) = 18.6%

Cost of debt = Interest rate × (1 – Corporate tax rate)
= 7 % × (1 – 30 %) = 4.9%

Cost of preferred stock = 6.5%

Therefore WACC at Book Value = 10/33*18.6% + 20/33*4.9% + 3/33* 6.5%

= 9.197%