Question

The weighted average cost of capital (WACC) is the weighted average after-tax cost of an organization’s various sources of financing such as debt and stock. In this chapter, we learned that the WACC is used when calculating economic value added. The WACC is also used in capital budgeting (Chapter 12).
Calculations for the weighted average cost of capital are usually found in finance textbooks. The formula is simple; we determine how much financing comes from various sources, and then calculate the weighted average. For example, suppose a company has $600,000 financing from debt at a pretax interest rate of 7% and $400,000 financing from equity having a cost of 9%. The company’s tax rate is 30%, and only the interest is tax deductible. The WACC is 6.54%, calculated as follows:


Although the computations are simple, it is not always easy to find the information needed for the computations. For example, consider the following balance sheet for Amazon.com as of December 31, 2002 (amounts in $ thousands):


Long-Term Debt and Other
The Company’s long-term debt and other long-term liabilities are summarized as follows:
4.75% Convertible Subordinated Notes ........ $1,249,807
6.875% PEACS ................... 724,500
10% Senior Discount Notes ............. 255,597
Long-term restructuring liabilities ........... 31,614
Euro currency swap ................. 12,159
Capital lease obligations ................ 8,491
Other long-term debt ................ 8,456
2,290,624
Less current portion of capital lease obligations ....... (7,506)
Less current portion of other long-term debt ....... (5,813)
$2,277,305

REQUIRED
A. Explain why book values might be poor estimates of market values for Amazon’s debt and stock.
B. Which liabilities do you think should be included in the WACC computation? Explain your choices.
C. Identify possible sources of information for the following:
1. Market value of common stock
2. Cost of equity capital
3. Market value for each type of debt
4. Pretax interest rates
5. Income taxrate


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  • CreatedJanuary 26, 2015
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