James Corporation has compiled the following information on its financing costs:
Type of Financing Book Value ($) Market Value ($) Cost (%)
Long term debt 5,000,000 2,000,000 10
Short term debt 5,000,000 5,000,000 8
Common stock 10,000,000 13,000,000 15
Total $20,000,000 20,000,000

The cost of debt in the above table is pre-tax.

James is in the 34 percent tax bracket and has a target debt-to-equity ratio of 100 percent.
James’s managers would like to keep the market values of short term and long term debt equal.

Calculate the after tax weighted average cost of capital (WACC) for James using:
a. Book – value weights
b. Market – value weights
c. Target weights

My attempts are as follows:

A. Book – value weights

Type of
Financing Book
Value ($) Before-tax
Cost of Debt After-tax
Cost of Debt Proportion Weighted Cost
Long term debt 5,000,000 0.10 0.066 0.25 0.0165
Short term debt 5,000,000 0.08 0.0528 0.25 0.0132
Common Stock 10,000,000 0.15 0.15 0.50 0.075
Total 20,000,000 0.1047
WACC 10.47%

B. Market – value weights

Type of
Financing Market
Value ($) Before-tax
Cost of Debt After-tax
Cost of Debt Proportion WeightedCost
Long term debt 2,000,000 0.10 0.066 0.10 0.0066
Short term debt 5,000,000 0.08 0.0528 0.25 0.0132
Common Stock 13,000,000 0.15 0.15 0.65 0.0975
Total 20,000,000 0.1173
WACC 11.73%


C. Target - value weigths
Equity 33 / 2 = 16.5 %
debt = 16.5%

Nusa, your book and market WACCs are spot-on... nice work.

As to the target weights, there are different ways that could be interpreted. Check your text to get a better feel for what's being assumed.

One common way of achieving a 'target' capital structure is to hold the equity financing constant while 're-balancing' the debt layers. This would mean that James Corp's management would carry out some refinancing that results in both long- and short-term debt having market vals of 3.5M each.

If this were the case, the WACC comes in at 11.83%. Still, there are different ways of getting to a target capital structure, so find out exactly what your text has in mind.

Sorry

A company has a target capital structure of 40% bedt and 60% common equity, with no preferred stock. Its before tax cost of debt is 12% and its marginal tax rate is 40%. The current stock price is P0= $22.50. The last dividend was D0= 2.00, and it is expected to grow at a constant rate of 7%. What is its cost of common equity and its WAAC?

Please start your own thread instead of tagging onto someone else's. That just gets confusing. If everyone put WAAC problems in the same thread all the time we'd have a big giant mess.

While you're at it, please read the guidelines for posting homework problems:
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Notice the original poster put down attempts at doing the problem.