Ace Repair

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

The WACC is used primarily for making long-term capital investment decisions, i.e., for capital budgeting. Thus, the WACC should include the types of capital used to pay for long-term assets, and this is typically long-term debt, preferred stock (if used), and common stock. Short-term sources of capital consist of (1) spontaneous, noninterest-bearing liabilities such as accounts payable and accruals and (2) short-term interest-bearing debt, such as notes payable. If the firm uses short-term interest-bearing debt to acquire fixed assets rather than just to finance working capital needs, then the WACC should include a short-term debt component. Noninterest-bearing debt is generally not included in the cost of capital estimate because these funds are netted out when determining investment needs, that is, net rather than gross working capital is included in capital expenditures.

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.

c. Based on the suggestion that the focus should be on market values, compute the weights

of debt, preferred stock, and common stock.

d. Are book value or market value weights better for calculating the firm’s weighted average cost of capital?

Book value weights use accounting values to measure the proportion of each type of capital in the firm’s financial structure while market value weights measure the proportion of each type of capital at its market value. Market value weights are appealing, because the market values of securities closely approximate the actual dollars to be received from their sale. Market value weights are clearly preferred over book value weights

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