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# Weighted Average Cost of Capital

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There are few ways to compute the weighted average cost of capital for a company: Of course one first estimates the 'cost' (in percentage terms) of the three main sources of capital: short term debt or liabilities, long term debt or liabilities and the cost of equity, and then computes the WACC using 'appropriate weights' as follows:

(1) Use the balance sheet of 'book values' of the different sources of capital as the 'weights'.

(2) Use the market value of short term debt (or liabilities), long term debt (or liabilities) and the market value of equity as 'weights'

(3) Use the "Target Capital Structure" of the company as the 'weights'.

Which of the three approaches should be adopted? Why?

#### Solution Preview

Weighted average cost of capital (WACC)
There are few ways to compute the weighted average cost of capital for a company: Of course one first estimates the 'cost' (in percentage terms) of the three main sources of capital: short term debt or liabilities, long term debt or liabilities and the cost of equity, and then computes the WACC using 'appropriate weights' as follows:
(1) Use the balance sheet of 'book values' of the different sources of capital as the 'weights'.
(2) Use the market value of short term debt (or liabilities), long term debt (or liabilities) and the market value of equity as 'weights'
(3) Use the "Target Capital Structure" of the company as the 'weights'.
Which of the three approaches should be adopted? Why?

There are three different weighting systems:
? book value weights- least desirable
? market value weights
? target (optimal) capital structure weights- best
If optimal weights are available, they should be used- they are superior to the other systems. If optimal ...

#### Solution Summary

The solution evaluates the different ways to compute the weighted average cost of capital for a company- 1) balance sheet 'book values' of the different sources of capital as the 'weights' 2) market value of short term debt (or liabilities), long term debt (or liabilities) and the market value of equity as 'weights' and 3) "Target Capital Structure" of the company as the 'weights' and makes a recommendation on which method is to be selected.

\$2.19

## Cost of Capital and Weighted Average Cost of Capital

1. Calculate the after-tax cost of a \$25 million debt issue that Pullman Manufacturing Corporation (40 percent marginal tax rate) is planning to place privately with a large insurance company. This long-term issue will yield 6.6 percent to the insurance company.

3. Calculate the after-tax cost of preferred stock for Bozeman-Western Airlines, Inc., which is planning to sell \$10 million of \$4.50 cumulative preferred stock to the public at a price of \$48 a share. The company has a marginal tax rate of 40 percent.

4. The following financial information is available on Fargo Fabrics, Inc.:
Current per-share market price 5 \$20.25
Current per-share dividend 5 \$1.12
Current per-share earnings 5 \$2.48
Beta 5 0.90
Expected market risk premium 5 6.4%
Risk-free rate (20-year Treasury bonds) 5 5.2%
Past 10 years earnings per share:
20X1 \$1.39 20X6 \$1.95
20X2 1.48 20X7 2.12
20X3 1.60 20X8 2.26
20X4 1.68 20X9 2.40
20X5 1.79 20Y0 2.48

7. The Ewing Distribution Company is planning a \$100 million expansion of its chain of discount service stations to several neighboring states. This expansion will be financed, in part, with debt issued with a coupon interest rate of 6.8 percent. The bonds have a 10-year maturity and a \$1,000 face value, and they will be sold to net Ewing \$990 per bond. Ewing's marginal tax rate is 40 percent. Preferred stock will cost Ewing 7.5 percent after taxes. Ewing's common stock pays a dividend of \$2 per share. The current market price per share is \$35. Ewing's dividends are expected to increase at an annual rate of 5 percent for the foreseeable future. Ewing expects to generate sufficient retained earnings to meet the common equity portion of the funding needed for the expansion.
Ewing's target capital structure is as follows:
Debt = 20%
Preferred stock = 5%
Common equity = 75%
Calculate the weighted cost of capital that is appropriate to use in evaluating this expansion program.

10. The Comfort Corporation manufactures sofas and tables for the recreational vehicle market. The firm's capital structure consists of 60 percent common equity, 10 percent preferred stock, and 30 percent long-term debt. This capital structure is believed to be optimal. Comfort will require \$120 million to finance expansion plans for the coming year. The firm expects to generate enough internal equity to meet the equity portion of its expansion needs. The cost of retained earnings is 18 percent. The firm can raise preferred stock at a cost of 15 percent. First-mortgage bonds can be sold at a pretax cost of 14 percent. The firm's marginal tax rate is 40 percent. Calculate the cost of capital for the funds needed to meet the expansion goal.

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