MINI CASE: CASTILLO PRODUCTS COMPANY The Castillo Products Company was started i
ID: 2710685 • 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
E.Cindy and Rob estimate that the market value of the common equity in the venture is $900,000 at the end of 2013. The market values of interest-bearing debt are judged to be the same as the recorded book values at the end of 2013. Estimate the market value-based weighted average cost of capital for Castillo Products.
F.Would you recommend to Cindy and Rob that they use the book value-based WACC estimate or the market value-based WACC estimate for planning purposes? Why?
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
E. Equity value is given as 900,000
Total debt would be 400,000 + 100,000 = 500,000
Before calculating WACC, we first have to determine cost of debt and cost of equity
Cost of Debt = Long term Govt. Bonds Rate + Default Risk Premium + Liquidity Premium = 7 + 6 + 3 = 16%
Cost of Equity = Long term Govt. Bonds Rate + market risk premium + investment risk premium = 7 + 6 + 2 * 6 = 25%
Now WACC can be calculated using the formula below
WACC = Debt Ratio * Cost of Debt + Equity ratio * cost of Equity
= (5/14) * 16% + (9/14) * 25% = 21.79%
F. I would recommend market value based WACC . look at the following example
In this company, the original investors invested $350,000 few years back. Today, the book value of the company is $350,000, (assume 100% dividend payout). But the market value of the company is $900,000.
The market value of the debt is $500,000 (also equal to its book value).
Now when estimating the cost of capital, we should use $900,000 (and not $350,000) in the cost of capital equation. The reason is the investors (of today) are actually investing $900,000 in the company today and hence they require return on $900,000 and not on $350,000.
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