Optimal capital structure weights are preferred because that is the structure that the firm will be presumably moving to in the future, which corresponds to the active dates of the projects we are using the WACC to evaluate. Unfortunately, optimal capital structure weights are not often available, especially to those outside of the firm. Market values are generally considered to be the next best option, and that is easy to calculate for the equity in publicly-traded firms because the share price and shares outstanding are readily available. For debt, it's not so easy because most corporate debt is not frequently traded so we don't have a ready source for prices. Therefore, for debt we generally use the book value for the weighting of debt.

The calculation of the WACC is then: (Pre-taxCost of Debt x (1-Tax Rate) x Weight of Debt)+ (Cost of Equity x Weight of Equity).

The Weight of Debt = (Book value of Debt/(Book value of Debt + Market value of Equity), and the Weight of Equity = (Market value of Equity/ (Book value of Debt + Market value of Equity).For a firm with a Pre-tax Cost of Debt of 6% and a Cost of equity of 10.7%, Book value of debt of $4 million, market value of equity of $6 million and a tax rate of 35%, WACC would be:

WACC = (.06 x (1-.35) x .40) + (.107 x .60) = 8.0%

To calculate the WACC let's go back to the Paley Products, Inc. financial statements for 2016 on p. 300 of the text. Paley has a pre-tax cost of debt of 5%, a cost of equity of 9.8%,10,000 shares outstanding at a market price of $129.08 each and a tax rate of 35%:

1, What are the weights of debt (all debt, the Bank Notes and the Mortgage) and equity for Paley and what is the weighted average cost of capital?

Paley Products. Inc. Sources and Uses ol Funds 2016 Sources of Funds Uses of Funds Net Income 5 53,040 Increase in Accounts Receivable 51 10.600 Depreciation 122.400 Increase in Inventory 316,200 Increase in Bank Notes 184,000 Capital Expenditures 95,300 Increase in Accounts Payable 151.000 Decrease in Mortgage 4.100 Increase in Accruals 20,500 Dividends 12,440 Total Sources $530,940 Total Uses $539,140 Decrease in Cash Balance 2016 5 8,200