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 40%. 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. 1.55%b. 1.72%c. 1.91%d. 2.13%e. 2.36%

Answer 1

Answer:

Difference = 2.36% (Option e)

Explanation:

Formula:

WACC = Re*(E/V) + Rd*(D/V)*(1-t)

Data (In Million)                  Book Value                 Market Value

E = Equity                           $65.00                        $225.00 ($22.50 x 10)

D = Debt                             $45.00                        $50.00

V = Value = E + D               $110.00                      $275.00

Re = Equity Rate                14%                            14%

Rd = Debt Rate                   6%                              6%

T = Tax Rate                      40%                             40%

WACC Book Value:

WACC = 14%*(65/110) + 6%*(45/110)*(1-0.40)  

WACC = 8.27273% + 1.47273%

WACC = 9.75%

WACC Market Value:

WACC = 14%*(225/275) + 6%*(50/275)*(1-0.40)  

WACC = 11.45455% + 0.65455 %

WACC = 12.11%

Difference = 12.11% - 9.75 = 2.36% (Option e)