Principles of Managerial Finance

a. Calculate the firm’s weighted average cost of capital using book value

weights.

b. Explain how the firm can use this cost in the investment decision-making

process.

11 – 12 WACC—Book weights and market weights Webster Company has compiled

the information shown in the following table.

a. Calculate the weighted average cost of capital using book value weights.

b. Calculate the weighted average cost of capital using market value weights.

c. Compare the answers obtained in parts aand b.Explain the differences.

11 – 13 WACC and target weights After careful analysis, Dexter Brothers has deter-

mined that its optimal capital structure is composed of the sources and target

market value weights shown in the following table.

The cost of debt is estimated to be 7.2%; the cost of preferred stock is estimated

to be 13.5%; the cost of retained earnings is estimated to be 16.0%; and the cost

of new common stock is estimated to be 18.0%. All of these are after-tax rates.

The company’s debt represents 25%, the preferred stock represents 10%, and

the common stock equity represents 65% of total capital on the basis of the mar-

ket values of the three components. The company expects to have a significant

amount of retained earnings available and does not expect to sell any new com-

mon stock.

a. Calculate the weighted average cost of capital on the basis of historical mar-

ket value weights.

Target market

Source of capital value weight

Long-term debt 30%

Preferred stock 15

Common stock equity  (^5)  (^5) 
Total 1

0

0

%
Source of capital Book value Market value After-tax cost
Long-term debt $4,000,000 $3,840,000 6.0%
Preferred stock 40,000 60,000 13.0
Common stock equity  (^1) , (^0)  (^6)  (^0) , (^0)  (^0)  (^0)   (^3) , (^0)  (^0)  (^0) , (^0)  (^0)  (^0)  17.0
Totals $

5

,

1

0

0

,

0

0

0

$

6

,

9

0

0

,

0

0

0

498 PART 4 Long-Term Financial Decisions
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