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​(Weighted average cost of capital​) Crawford

Enterprises is a publicly held company located in​ Arnold, Kansas. The firm began as a small tool and die
shop but grew over its​ 35-year life to become a leading supplier of metal fabrication equipment used in
the farm tractor industry. At the close of​ 2019, the​ firm's balance sheet appeared as​ follows: LOADING....
At present the​ firm's common stock is selling for a price equal to its book​ value, and the​ firm's bonds are
selling at par.​ Crawford's managers estimate that the market requires a return of 15 percent on its
common​ stock, the​ firm's bonds command a yield to maturity of 11 ​percent, and the firm faces a tax rate
of 24 percent. a. What is​ Crawford's weighted average cost of​ capital? b. If​ Crawford's stock price were to
rise such that it sold at 1.5 times book​ value, causing the cost of equity to fall to 13 ​percent, what would
the​ firm's cost of capital be​ (assuming the cost of debt and tax rate do not​ change)? c. Crawford is
considering a new business opportunity involving the acquisition of a trucking firm. What do you think the
firm should do to select an appropriate cost of capital for evaluating this​ acquisition?
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Expert Answer

Dhamodharan S answered this

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Part a)

Cost of debt after tax = cost of debt before tax*(1-tax rate) = 11%*(1-0.24) = 11%*0.76 = 8.36%

Since the common stock is selling at book value & bond is selling par, Book of debt & equity is considered
as market value.

WACC
Cost after
Type Market value Proportion (Proportion*cost after
tax
tax)

Equity 19,886,000 19,886,000/30,076,000 = 66.12% 15% 9.92%

Bond 10,190,000 10,190,000/30,076,000 = 33.88% 8.36% 2.83%

30,076,000 12.75%

Crawford's weighted average cost of capital = 12.75%

Part b)

Market value of equity = book value*1.5times = 19,886,000*1.5 = 29,829,000

WACC
Cost after
Type Market value Proportion (Proportion*cost after
tax
tax)

Equity 29,829,000 29,829,000/40,019,000 = 74.54% 13% 9.69%

Bond 10,190,000 10,190,000/40,019,000 = 25.46% 8.36% 2.13%

40,019,000 11.82%

Crawford's weighted average cost of capital = 11.82%

Part c)

To select approriate cost of capital, first determine approriate cost of equity by using Capital asset pricing
model (CAPM) by using relevant beta of the trucking firm & calculate. Thereafter based on debt-equity
ratio determine weighted average cost of capital for the acquisition.
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