WACC Based on Market Value

In฀Example฀9.1,฀we฀used฀the฀book-value฀weights฀of฀the฀long-term฀debt฀and฀preferred฀equity฀to฀calculate฀ WACC. Accordingly, the result is defined as the book-value฀WACC,฀or฀the฀WACC฀based฀on฀past฀histori- cal฀values.฀However,฀because฀the฀market฀constantly฀re-values฀a฀firm’s฀securities,฀the฀book-value฀weights฀ probably฀do฀not฀represent฀true฀present weights. To get the present weights, the total market value of each type฀of฀capital฀source฀needs฀to฀be฀determined.

To determine the relative weights for the market-value฀WACC,฀we฀begin฀by฀determining฀the฀total฀ market value of each type of security. Once that is done, the relative weight of each source of capital is determined฀by฀dividing฀its฀market฀value฀by฀the฀total฀market฀value฀of฀the฀firm’s฀capital฀structure.

Example 9.4:฀ Suppose฀ that฀ the฀ total฀ value฀ of฀ debt฀ carried฀ by฀ the฀ ABC฀ Corporation฀ (see฀ Example฀ 9.1)฀ is฀ $3,850,000, there are 500,000 shares of preferred stock at a market value of $1/share, and there are 1,000,000 shares฀of฀common฀stock฀outstanding฀with฀a฀market฀value฀of฀$5.50/share.฀Suppose฀also฀that฀the฀returns฀are฀to฀be฀ the฀same฀as฀given฀in฀Example฀9.1—that฀is,฀an฀8฀percent฀return฀on฀borrowing,฀a฀10฀percent฀return฀on฀preferred฀ stock,฀and฀a฀13฀percent฀return฀on฀common฀stock.฀For฀these฀conditions,฀what฀would฀be฀the฀value฀for฀the฀WACC฀ based฀on฀the฀market฀value฀of฀the฀capital฀structure?

Solution: Figure 9-10 is a spreadsheet solution. The total market values for preferred and common stocks are calculated฀by฀entering฀=B4*C4฀in฀Cell฀D4฀and฀copying฀the฀entry฀to฀Cell฀D5.

The฀percentages฀of฀the฀total฀market฀value฀for฀each฀source฀of฀funds฀are฀calculated฀by฀entering฀=D3/$D$6฀ in Cell E3 and copying the entry to Cells E4:E5.

Figure฀9-10

WACC Based on Market Value

1 Example 9.4: TURNBULL CORP., COST OF CAPITAL BASED ON MARKET VALUE

Market

Percentage of

Amount of

After-Tax 2 Source of Funds

Number of

Value, per

Total Market

Capital to be

Rate of Return Cost 3 Debt (i.e., Borrowing)

8.0% $ 31,269 4 Preferred Stock

10.0% $ 5,076 5 Common Stock

Market-Value WACC

Key Cell Entries

D4: =B4*C4, copy to D5 D6: =SUM(D3:D5) E3: =D3/$D$6, copy to E4:E5 E6: =SUM(E3:E5) F3: =E3*$F$6, copy to F4:F5 G6: =SUMPRODUCT(F3:F5,G3:G5)/F6 or H6/F6 H3: =F3*G3, copy to H4:H5 H6: =SUM(H3:H5)

Cost of Capital ❧ 303

The฀amounts฀of฀capital฀to฀be฀raised฀from฀each฀source฀are฀calculated฀by฀entering฀=E3*$F$6฀in฀Cell฀F3฀and฀ copying the entry to F4:F5.

The฀after-tax฀costs฀of฀funds฀from฀each฀source฀are฀calculated฀by฀entering฀=F3*G3฀in฀Cell฀H3฀and฀copying฀ the฀entry฀to฀H4:H5.฀The฀total฀after-tax฀cost฀is฀calculated฀by฀entering฀=SUM(H3:H5)฀in฀Cell฀H6. The฀market-value฀WACC฀is฀calculated฀in฀by฀entering฀=SUMPRODUCT(F3:F5,G3:G5)/F6฀or฀H6/F6฀in฀ Cell฀G6.฀The฀result฀is฀a฀WACC฀equal฀to฀10.89%. Note฀that฀the฀market-value฀WACC฀(10.89%)฀is฀higher฀than฀the฀book-value฀WACC฀(10.60%)฀computed฀in฀ Example฀9.1.฀This฀is฀because฀ABC’s฀market-based฀capital฀structure฀has฀a฀higher฀percentage฀of฀common฀equity฀ (55.8%฀vs.฀50%),฀which฀has฀the฀highest฀expected฀rate฀of฀return,฀and฀a฀lower฀percentage฀of฀debt฀(39.1%฀vs.฀45%),฀ which has the lowest expected rate of return.

WACC Based on Market Value