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. 4. 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 2021. 5. 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. 6. 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?

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. 4. 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 2021. 5. 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. 6. 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?

FINANCIAL ACCOUNTING

10th Edition

ISBN:9781259964947

Author:Libby

Publisher:Libby

Chapter1: Financial Statements And Business Decisions

Section: Chapter Questions

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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.

4. 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 2021.

5. 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.

6. 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?

2020
2021
Net sales
Cost of goods sold
Gross profit
Marketing
General and administrative
$900,000
540,000
360,000
90,000
250,000
40,000
$1,500,000
900,000
600,000
150,000
250,000
Depreciation
EBIT
40,000
160,000
60,000
100,000
25,000
$ 75,000
-20,000
Interest
45,000
-65,000
Earnings before taxes
Income taxes
Net income (loss)
-$ 65,000
2009
2010
$ 50,000
200,000
400,000
650,000
450,000
-100,000
350,000
$1,000,000
$ 20,000
280,000
500,000
800,000
Cash
Accounts receivable
Inventories
Total current assets
Gross fixed assets
540,000
Accumulated depreciation
Net fixed assets
-140,000
400,000
$1,200,000
Total assets
Accounts payable
$ 130,000
50,000
90,000
270,000
300,000
150,000
200,000
80,000
$1,000,000
$ 160,000
70,000
100,000
330,000
400,000
150,000
Accruals
Bank loan
Total current liabilities
Long-term debt
Common stock (.05 par)
Additional paid-in-capital
Retained earnings
Total liabilities and equity
200,000
120,000
$1,200,000
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