The Book Value Weights

The book value weights are based on arbitrary accounting policies that are used to calculate retained earnings and value of assets. Thus they are not reflecting economic values. It is very difficult to justify the use of the book value weights in theory.

Market value weights are theoretically superior to book value weights. They reflect economic values and are not influenced by accounting policies. They are also consistent with the market determined component costs. The difficulty in using market value weights is that the market prices securities fluctuate widely and frequently. A market value based target capital structure means that the amounts of debt and equity are continuously adjusted as the value of the firm charges.

Q-2

a)

The required rate of return to debtholders is not equal to the company’s cost of debt. Part of the total cost is paid by the government in the sense; the company can deduct interest payments for the total cost. The risk premium paid by the Ace Repair’s current method of estimating it’s before tax cost of debt is based on the 10% coupon rate on its existing long-term bond. These bonds are rated single A, will mature in 17 years, and can be called in 3 years. So, Ace Repair’s current method of estimating it’s before tax cost was equal to the coupon rate. It also seems that firm is currently paying a 2% risk premium vs. the 8% being paid by other A-rated corporate long-term bonds. The controller has used the book value to calculate the WACC, this would have been a better practice if the company’s debt was not publicly traded. The professor’s suggestion about some bond rating and analysts focused on book values, they could be looking short term bonds.

b)

Since debt and preferred stock are contractual obligations that have easily determined costs, it’s more difficult to measure rs. The controller is right by mentioning the reinvestment of the shares preceding has to sell at same rate as the rate of return promised to investor. Generally to calculate cost of equity, we use three methods, all three of them and choose the best which fits the scenario or the input data available. The controller has assumed $2.50 flotation cost for the new shares issued accounting for hidden cost applied.

a)

There is no right or wrong estimate for cost of debt, it depends on the specific assets to be financed and on capital market conditions created over time. Since long term bonds are used to accumulate firm’s capital, cost of long