Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVI. Cost of Capital and
Long−Term Financial
Policy- Cost of Capital © The McGraw−Hill^533
Companies, 2002
To calculate the weighted average cost of debt, we take the percentage of the total
debt represented by each issue and multiply by the yield on the issue. We then add to get
the overall weighted average debt cost. We use both book values and market values here
for comparison. The results are as follows:
As these calculations show, Eastman’s cost of debt is 7.41 percent on a book value
basis and 7.38 percent on a market value basis. Thus, for Eastman, whether market val-
ues or book values are used makes little difference. The reason is simply that the market
values and book values are similar. This will often be the case and explains why com-
panies frequently use just book values for debt in WACC calculations. Also, Eastman
has no preferred stock, so we don’t need to consider a cost of preferred.
Eastman’s WACC We now have the various pieces necessary to calculate Eastman’s
WACC. First, we need to calculate the capital structure weights. On a book value basis,
Eastman’s equity and debt are worth $1.611 billion and $1.493 billion, respectively. The
total value is $3.104 billion, so the equity and debt percentages are $1.611 billion/3.104
billion .52 and $1.493 billion/3.104 billion .48. Assuming a tax rate of 35 percent,
Eastman’s WACC is:
WACC .52 10.28% .48 7.47% (1 .35)
7.68%Thus, using book value capital structure weights, we get about 7.7 percent for Eastman’s
WACC.
If we use market value weights, however, the WACC will be higher. To see why, no-
tice that on a market value basis, Eastman’s equity and debt are worth $3.200 billion and
$1.436 billion, respectively. The capital structure weights are therefore $3.200 bil-
lion/4.636 billion .69 and $1.436 billion/4.636 billion .31, so the equity percentage
is much higher. With these weights, Eastman’s WACC is:
Book
Value
Coupon (face value, Price Yield to
Rate Maturity in millions) (% of par) Maturity
6.375% 2004 $500 100.294 6.236
7.25 2024 496 88.806 8.363
7.625 2024 200 103.453 7.308
7.60 2027 297 96.763 7.896CHAPTER 15 Cost of Capital 505Book
Value Market
Coupon (face value, Percentage Value Percentage Yield to Book Market
Rate in millions) of Total (in millions) of Total Maturity Values Values
6.375% $ 500 .34 $ 501.5 .35 6.236% 2.12% 2.18%
7.25 496 .33 440.5 .31 8.363 2.76 2.59
7.625 200 .13 206.9 .14 7.308 0.95 1.02
7.60 297 .20 287.4 .20 7.896 1.58 1.58
Total $1,493 1.00 $1,436.3 1.00 7.41% 7.38%Weighted Average
Debt Cost
(% of total
yield to maturity)