Question

The Paulson Company's year-end balance sheet is shown below. Its cost of common equity is 15%, its before-tax cost of debt is 10%, and its marginal tax rate is 25%. Assume that the firm's long-term debt sells at par value. The firm's total debt, which is the sum of the company's short-term debt and long-term debt, equals $1,136. The firm has 576 shares of common stock outstanding that sell for $4.00 per share. Liabilities And Equity Assets Accounts payable and accruals Cash $120 $10 Accounts receivable 240 Short-term debt 46 Long-term debt 1,090 Inventories 360 Plant and equipment, net Common equity 2,160 1,734 Total liabilities and equity Total assets $2,880 $2,880 Calculate Paulson's WACC using market-value weights. Do not round intermediate calculations. Round your answer to two decimal places. 34.52 %

Answer 1

Solution:

From the above questions, the market value common equity and debt to be used as weights.

Market Value of Common Stock = Common Stock outstanding * Market Value per Share

Market Value per Share = $ 4.00

Common Stock Outstanding = 576 share

Market Value of Common Stock = $ 4.00 * 576 = $2,304

Here , Debt of long term will be considered and short term debt is not considered. As the reason for such is , long term debts are part of capital of the company and are not treated as operational liabilities unlike in short term debts. In other words, short term debts are not a part of capital hence will not be relevant for Weighted Average Cost of Capital ( WACC).

Since, Long term debts sells at par value, therefore the $ 1,090 shall be the market value.

Now, Constructing WACC .

Sources of Finance	Amounts (In $)	Weights (c) (Note1)	Cost (d) (Note 2 &3)	Weighted Cost (in %) (e) = (c)*(d)
Common Equity	2,304	0.6788	15%	10.182
Debts	1,090	0.3211	7.5%	2.40825
Total Amount	3,394		WACC	12.59025

WACC based on market value weights shall be 12.59%

Note:

1. Weights refer to the amount of proportion of each sources of finance in the total capital amount. Here, as you can see from the above table Amounts of Common equity in total amount is $ 2,304 in the amount of $3,394, this means weight of common equity shall be $ 2,304 / $ 3,394 = 0.6788, similarly for debts it will be $ 1,090 / $3,394 = 0.3211.
2. The cost of common equity is denoted by K_e and the cost of debts is denoted by K_d , Now in the given question cost of common equity is 15%.
3. We shall calculate the cost of debts by this formula, Post tax  K_d = Interest on Debts ( 1 - tax rate ), here pre tax cost of Debts is 10% and for calculating WACC , we must determine the Post tax Cost of Debts, therefore Post tax cost of debts = 10% (1 - 0.25), since tax rate is 25% and can be written as 0.25, hence calculating the above , 10%(1-0.25) = 10%*0.75= 7.50%.