ducts Company was started in 2008. The company manufactures components for personal decision assistant (PDA) products and for other handheld electronic products. A difficult operating year, 2009, was followed by a profitable 2010. 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 la
MINI CASE
The Castillo Products Company was started in 2008. The company manufactures components for personal decision assistant (PDA) products and for other handheld electronic products. A difficult operating year, 2009, was followed by a profitable 2010. 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 2009 and 2010.
Castillo Products Company
|
|
2020 |
2021 |
|
Net sales |
$900,000 |
$1,500,000 |
|
Cost of goods sold |
540,000 |
900,000 |
|
Gross profit |
360,000 |
600,000 |
|
Marketing |
90,000 |
150,000 |
|
General and administrative |
250,000 |
250,000 |
|
|
40,000 |
40,000 |
|
EBIT |
-20,000 |
160,000 |
|
Interest |
45,000 |
60,000 |
|
Earnings before taxes |
-65,000 |
100,000 |
|
Income taxes |
0 |
25,000 |
|
Net income (loss) |
-$ 65,000 |
$ 75,000
|
|
|
2009 |
2010 |
|
Cash |
$ 50,000 |
$ 20,000 |
|
|
200,000 |
280,000 |
|
Inventories |
400,000 |
500,000 |
|
Total current assets |
650,000 |
800,000 |
|
Gross fixed assets |
450,000 |
540,000 |
|
|
-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 |
|
|
80,000 |
120,000 |
|
Total liabilities and equity |
$1,000,000 |
$1,200,000 |
a) Calculate the: net profit margin; total-sales-to-total-assets ratio; the equity multiplier; and the return on equity for both 2020 and 2021 for the Castillo Products Corporation. Describe what happened in terms of financial performance between the two years.
b) Estimate the cost of short-term bank loans, long-term debt, and common equity capital for the Castillo Products Corporation.
c) Although, Castillo Products paid a low effective tax rate in 2021, a 30 percent income tax rate is considered more appropriate when looking to the future. Estimate the after-tax cost of short-term bank loans, long-term debt, and the venture’s common equity.
d) Estimate the weighted average cost of capital (WACC) for the Castillo Products Corporation using the book values of interest-bearing debt and
e) Cindy and Rob estimate that the market value of the common equity in the venture is $900,000 at the end of 2021. The market values of interest-bearing debt are judged to be the same as the recorded book values at the end of 2010. 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?
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