B.

Target Weights

Target weights are based in a firm’s desire capital structure. Firms using target weights establish these
proportions on the basis of optimal capital structure they wish to attain. The preferable approach
through is to use target weight based on market values rather than historical weights.

Illustrative case 27-12. Calculation of WACC Using target Weights

In addition to the data provided in A and B, Copper Pipe Company has determined that its optimal
capital structure is as follows:

Bonds 40%
Preferred share 10
Ordinary equity share 50
100%

The Firms wants to maintain its optimal capital structure increasing future long-term capital. The firm
also expects to have sufficient retained earnings so that it can use the cost of retained earnings as the
ordinary equity cost component. If Copper Pipe Company raises new capital in target proportions, the
firm’s WACC can be computed as follows:

Target Specific Weighted Cost

Weights Cost of Capital
Bonds 40% 6.6% 2.64%
Preferred share 10% 10.21% 1.02%
Ordinary equity share 50% 13% 6.5%
100% WACC 10.16%

Illustrative Comprehensive Case: Calculation of Components Cost of Capital

Suppose that Walter Corporation has a Beta of .80. The market rate risk premium is 6%, and the risk-
free rate is 6%. Walter’s last dividend was P1.20 per share and the dividend is expected to grow at 8%
indefinitely. The stock currently sell for P45 per share.

Required:
1. Using the CAPM approach, what is Walter’s cost of equity capital or expected return on Walter’s
ordinary equity share?
2. Using the dividend growth model, what is the expected return on Walter’s ordinary equity
share?
3. What is the average cost of equity?
4. In addition to the information given in the previous problem, Walter has a target debt-equity
ratio of 50 percent. Its cost of debt is 9 percent before taxes. If the tax rate is 35%, what is the
WACC?
5. Suppose that Walter is seeking P30 million for a new project. The necessary funds will have to
be raised externally. Walter’s flotation costs for selling debt and equity are 2% and 16%,
respectively. If flotation costs are considered, what is the true cost of the new project?
Solution:
1. Using the CAPM approach, the expected return on Walter’s ordinary equity share is computed
as follows:

𝐾𝑁 = 𝑟𝑓 + 𝑏𝑖 (𝑟𝑚 − 𝑟𝑓 )

Where: 𝑟𝑓 = Risk-free rate of return

𝑟𝑚 = Expected return on the market portfolio
𝑟𝑚 − 𝑟𝑓 = Market risk premium
𝑏𝑖 = Beta coefficient of ordinary equity share i

𝐾𝑁 = 6% + .80 (6%) = 10.80%

2. Using the dividend growth rate approach, the expected return on ordinary equity is:

𝐷𝑖
𝐾𝑁 = +𝑔
𝑃𝑜

Where: 𝐷𝑖 = Projected dividend per share

𝑃𝑜 = Current price of ordinary equity share
g = Dividend growth rate

P1.2 x 1.08
𝐾𝑁 = + .08
P45

P1.296
= + .08
P45

= 10.88%

3.
The average cost of
Ordinary equity share
10.8% + 10.88%
=
2

= 10.84%

4. The target debt-equity ratio is 50% hence, Walter uses P.50 debt for every P1 in equity. The
firm’s capital structure is therefore 1/3 debt and 2/3 equity.

The WACC is thus:

WACC = (10.84%) (2/3) + [(9%(1-35%)] (1/3)
= 7.23% + 1.95%
= 9.18%
5. Since Walter uses both debt and equity to finance the operations, the weighted average
flotation costs (𝑓𝐴 ) should first be computed.

𝑓𝐴 = (16%) (2/3) + 2% (1/3)

= 11.33%

If Walter needs P30 million after flotation costs, then the true cost in the project is:

𝑃30𝑀
=
1− .1133

𝑃30𝑀
=
.8867

= P33.83M