MINI CASE: CASTILLO PRODUCTS COMPANY The Castillo Products Company was started i
ID: 2710683 • Letter: M
Question
MINI CASE: CASTILLO PRODUCTS COMPANY
The Castillo Products Company was started in 2011. The company manufactures components for personal decision assistant (PDA) products and for other handheld electronic products. A difficult operating year, 2012, was followed by a profitable 2013. The founders (Cindy and Rob Castillo) are interested in estimating their cost of financial capital since they are expecting to secure additional external financing to support planned growth.
Short-term bank loans are available at an 8 percent interest rate. Cindy and Rob believe that the cost of obtaining long-term debt and equity capital will be somewhat higher. The real interest rate is estimated to be 2 percent and a long-run inflation premium is estimated at 3 percent. The interest rate on long-term government bonds is 7 percent. A default-risk premium on long-term debt is estimated at 6 percent; plus Castillo Products is expecting to have to pay a liquidity premium of 3 percent due to the illiquidity associated with its long-term debt. The market risk premium on large-firm common stocks over the rate on long-term government bonds is estimated to be 6 percent. Cindy and Rob expect that equity investors in their venture will require an additional investment risk premium estimated at two times the market risk premium on large-firm common stocks.
Following are income statements and balance sheets for the Castillo Products Company for 2012 and 2013.
Castillo Products Company
2012
2013
Net sales
$900,000
$1,500,000
Cost of goods sold
540,000
900,000
Gross profit
360,000
600,000
Marketing
90,000
150,000
General and administrative
250,000
250,000
Depreciation
40,000
40,000
EBIT
-20,000
160,000
Interest
45,000
60,000
Earnings before taxes
-65,000
100,000
Income taxes
0
25,000
Net income (loss)
-$ 65,000
$ 75,000
2012
2013
Cash
$ 50,000
$ 20,000
Accounts receivable
200,000
280,000
Inventories
400,000
500,000
Total current assets
650,000
800,000
Gross fixed assets
450,000
540,000
Accumulated depreciation
-100,000
-140,000
Net fixed assets
350,000
400,000
Total assets
$1,000,000
$1,200,000
Accounts payable
$ 130,000
$ 160,000
Accruals
50,000
70,000
Bank loan
90,000
100,000
Total current liabilities
270,000
330,000
Long-term debt
300,000
400,000
Common stock (.05 par)
150,000
150,000
Additional paid-in-capital
200,000
200,000
Retained earnings
80,000
120,000
Total liabilities and equity
$1,000,000
$1,200,000
D.Estimate the weighted average cost of capital (WACC) for the Castillo Products Corporation using the book values of interest-bearing debt and stockholders’ equity capital at the end of 2013.
2012
2013
Net sales
$900,000
$1,500,000
Cost of goods sold
540,000
900,000
Gross profit
360,000
600,000
Marketing
90,000
150,000
General and administrative
250,000
250,000
Depreciation
40,000
40,000
EBIT
-20,000
160,000
Interest
45,000
60,000
Earnings before taxes
-65,000
100,000
Income taxes
0
25,000
Net income (loss)
-$ 65,000
$ 75,000
2012
2013
Cash
$ 50,000
$ 20,000
Accounts receivable
200,000
280,000
Inventories
400,000
500,000
Total current assets
650,000
800,000
Gross fixed assets
450,000
540,000
Accumulated depreciation
-100,000
-140,000
Net fixed assets
350,000
400,000
Total assets
$1,000,000
$1,200,000
Accounts payable
$ 130,000
$ 160,000
Accruals
50,000
70,000
Bank loan
90,000
100,000
Total current liabilities
270,000
330,000
Long-term debt
300,000
400,000
Common stock (.05 par)
150,000
150,000
Additional paid-in-capital
200,000
200,000
Retained earnings
80,000
120,000
Total liabilities and equity
$1,000,000
$1,200,000
Explanation / Answer
after-tax cost of short-term bank loans = short term debt * (1 - tax rate ) = 8 * (1 - 0.3) = 5.6%
after-tax cost of long-term debt = (Long term govt debt + default premium + liquidity premium )* (1 - tax rate ) = ( 7 + 6 +3 )* (1 - 0.3) = 11.2%
cost of common equity. = Long term govt debt + beta * market risk premium = 8 +2 *6 = 20%
Bank loan = 100000
Long-term debt = 400000
equity = 150,000 + 200,000 + 120,000 = 470000
Total capital = Bank loan + Long-term debt + equity
= 100000 + 400000 + 470000 = 970000
WACC = after-tax cost of short-term bank loans * Bank loan/Total capital + after-tax cost of long-term debt* Long-term debt /Total capital +cost of common equity.* equityTotal capital
= 5.6*100000/970000 + 11.2*400000/970000 + 20*470000/970000 = 14.89%
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