Question 13.1: Suppose Kenai Corp. has debt with a book (face) value of $10...
Suppose Kenai Corp. has debt with a book (face) value of $10 million, trading at 95% of face value. It also has book equity of $10 million, and 1 million shares of common stock trading at $30 per share. What weights should Kenai use in calculating its WACC?
Plan
Equation 13.2 tells us that the weights are the fractions of Kenai financed with debt and financed with equity. Furthermore, these weights should be based on market values because the cost of capital is based on investors’ current assessment of the value of the firm, not on accounting-based book values. As a consequence, we can ignore the book values of debt and equity.
r_{wacc}= (Fraction of Firm Value Financed by Equity)(Equity Cost of Capital)+(Fraction of Firm Value Financed by Debt)(Debt Cost of Capital)=(Asset Cost of Capital) (13.2)
Execute
$10 million in debt trading at 95% of face value is $9.5 million in market value. One million shares of stock at $30 per share is $30 million in market value. So, the total market value of the firm is $39.5 million.
The weights are
9.5\div 39.5=24.1\% for debt and 30\div 39.5=75.9\% for equity.
Evaluate
When calculating its overall cost of capital, Kenai will use a weighted average of the cost of its debt capital and the cost of its equity capital, giving a weight of 24.1% to its cost of debt and a weight of 75.9% to its cost of equity.