Case 54 Questions
Questions 1. a. Discuss the specific items of capital that should be included in the WACC. The WACC calculation should include all the sources of capital like common stock, preferred stock, bonds and any other long-term debt. b. The comptroller currently finds the weights for the weighted average cost of capital (WACC) from information from the balance sheet shown in Table 2. Compute the book value weights that the comptroller currently uses for the company’s capital structure. (In Millions)
c. Based on the suggestion that the focus should be on market values, compute the weights of debt, preferred stock, and common stock. (In Millions)
MV $
MV %
LT Debt
48.36
19.5%
Preferred
10.00
4.0%
Common
189.90
76.5%
Total
248.26
100%
d. Are book value or market value weights better for calculating the firm’s weighted average cost of capital? Market value weights are better for calculating the firms weighted average cost of capital because they are forward-looking and based on what the asset is expected to produce in the future. Book values reflect historical costs. 2. a. Critique Ace Repair’s current method of estimating its before-tax cost of debt. Ace Repairs current method of estimating its before-tax cost of debt is using its coupon rate of the most recent LT bond. This rate is not a good estimate b. Is the earnings yield (E/P) an appropriate measure of the firm’s cost of equity? Earnings yield is not an appropriate measure of the firms cost of equity because it only shows the current year’s earnings and the current share price. The future growth isn’t considered in the earnings yield. 3. a. What is the best estimate of Ace’s cost of debt? The best estimate of Ace’s Cost of Debt is 8.3%, the yield on Ace’s current debt. b. Should flotation costs be included in the component cost of debt calculation? Explain. Flotation costs will impact the calculation of the cost
c. Based on the suggestion that the focus should be on market values, compute the weights of debt, preferred stock, and common stock. (In Millions)
MV $
MV %
LT Debt
48.36
19.5%
Preferred
10.00
4.0%
Common
189.90
76.5%
Total
248.26
100%
d. Are book value or market value weights better for calculating the firm’s weighted average cost of capital? Market value weights are better for calculating the firms weighted average cost of capital because they are forward-looking and based on what the asset is expected to produce in the future. Book values reflect historical costs. 2. a. Critique Ace Repair’s current method of estimating its before-tax cost of debt. Ace Repairs current method of estimating its before-tax cost of debt is using its coupon rate of the most recent LT bond. This rate is not a good estimate b. Is the earnings yield (E/P) an appropriate measure of the firm’s cost of equity? Earnings yield is not an appropriate measure of the firms cost of equity because it only shows the current year’s earnings and the current share price. The future growth isn’t considered in the earnings yield. 3. a. What is the best estimate of Ace’s cost of debt? The best estimate of Ace’s Cost of Debt is 8.3%, the yield on Ace’s current debt. b. Should flotation costs be included in the component cost of debt calculation? Explain. Flotation costs will impact the calculation of the cost