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7.41%

7.38%

As these calculations show, Eastman's cost of debt is 7.41 percent on a book value basis and 7.38 percent on a market value basis. Thus, for Eastman, whether market values or book values are used makes little difference. The reason is simply that the market values and book values are similar. This will often be the case and explains why companies frequently use just book values for debt in WACC calculations. Also, Eastman has no preferred stock, so we don't need to consider a cost of preferred.

Eastman's WACC We now have the various pieces necessary to calculate Eastman's WACC. First, we need to calculate the capital structure weights. On a book value basis, Eastman's equity and debt are worth $1.611 billion and $1.493 billion, respectively. The total value is $3.104 billion, so the equity and debt percentages are $1.611 billion/3.104 billion = .52 and $1.493 billion/3.104 billion = .48. Assuming a tax rate of 35 percent, Eastman's WACC is:

WACC = .52 X 10.28% + .48 X 7.47% X (1 - .35) = 7.68%

Thus, using book value capital structure weights, we get about 7.7 percent for Eastman's WACC.

If we use market value weights, however, the WACC will be higher. To see why, notice that on a market value basis, Eastman's equity and debt are worth $3.200 billion and $1.436 billion, respectively. The capital structure weights are therefore $3.200 billion/4.636 billion = .69 and $1.436 billion/4.636 billion = .31, so the equity percentage is much higher. With these weights, Eastman's WACC is:

© The McGraw-Hill Companies, 2002

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VI. Cost of Capital and Long-Term Financial Policy

15. Cost of Capital

© The McGraw-Hill Companies, 2002

PART SIX Cost of Capital and Long-Term Financial Policy

WACC = .69 X 10.28% + .31 X 7.38% X (1 - .35) = 8.58%

Thus, using market value weights, we get almost 8.6 percent for Eastman's WACC, which is almost a full percentage point higher than the 7.7 percent we got using book value weights.

As this example illustrates, using book values can lead to trouble, particularly if equity book values are used. Going back to Chapter 3, recall that we discussed the market-to-book ratio (the ratio of market value per share to book value per share). This ratio is usually substantially bigger than 1. For Eastman, for example, verify that it's about 2.0; so book values significantly overstate the percentage of Eastman's financing that comes from debt. In addition, if we were computing a WACC for a company that did not have publicly traded stock, we would try to come up with a suitable market-to-book ratio by looking at publicly traded companies, and we would then use this ratio to adjust the book value of the company under consideration. As we have seen, failure to do so can lead to significant underestimation of the WACC.

Our nearby Work the Web box explains more about the WACC and related topics.

Work the Web

So how does our estimate of the WACC for Eastman compare to others? One place to find estimates for WACC is www.stockbasics.com. We went there and found the following information for Eastman.

EASTMAN CHEMICAL COMPANY (EMN )

Highlights - Fiscal year ended: December 31, 2000

Item

Economic Earnings Free Cash Flow Market Value-added Economic equity P.QKRMflas Economic Capital Cost of Capital Return on Capital Operating Profil MVA to Equity Value-added ratio (VAR)

ECONOMIC DATA $ 000

46,701 264,369 644,471 3,096,750 2,203,691 5,300,441

Per Share

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