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5 October, 11:59

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%

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  1. 5 October, 12:27
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    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)
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