Case 54 Essay

Questions


    1. a. Discuss the specific items of capital that should be included in the WACC.

  The capital that should be included in the WACC is the 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.

    Common stock weight 28.6%

Preferred stock weight 14.3%

Long-term debt 57.1%

    c. Based on the suggestion that the focus should be on market values, compute the weights of debt, preferred stock, and common stock.

MV debt weight 19.4%

MV preferred weight 4.2%

MV common stock weight 76.3%

    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 WACC because market value is the worth today and is more like the current situation and it can change daily.

    2. a. Critique Ace Repair’s current method of estimating its before-tax cost of debt.

    b. Is the earnings yield (E/P) an appropriate measure of the firm’s cost of equity?

    3. a. What is the best estimate of Ace’s cost of debt?

    b. Should flotation costs be included in the component cost of debt calculation? Explain.

    c. Should the nominal cost of debt or the effective annual rate be used? Explain.

    d. How valid is an estimate of the cost of debt based on the yield to maturity of Ace’s debt (ignore the call provision in 3 years) if the firm plans to issue 20-year long-term debt?

    e. What other methods could be used to estimate the cost of debt if, for example, Ace’s outstanding debt had not been traded recently?

    4. a. What is Ace’s cost of preferred stock?

    b. Ace’s preferred stock is more risky to investors than its debt, yet the before-tax yield on its...