The Castillo Products Company was started in 2017. The company manufactures components for personal decision assistant (PDA) products and for other handheld electronic products. A difficult operating year, 2018, was followed by a profitable 2019. 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 2018 and 2019.
The Castillo Products Company was started in 2017. The company manufactures components for personal decision assistant (PDA) products and for other handheld electronic products. A difficult operating year, 2018, was followed by a profitable 2019. 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 2018 and 2019.
Financial Management: Theory & Practice
16th Edition
ISBN:9781337909730
Author:Brigham
Publisher:Brigham
Chapter21: Dynamic Capital Structures And Corporate Valuation
Section: Chapter Questions
Problem 5MC: David Lyons, CEO of Lyons Solar Technologies, is concerned about his firms level of debt financing....
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Transcribed Image Text:Mini Case
The Castillo Products Company was started in 2017. The company manufactures components for
personal decision assistant (PDA) products and for other handheld electronic products. A difficult
operating year, 2018, was followed by a profitable 2019. 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 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 2018
and 2019.
Castillo Products Company
Net sales
Cost of goods sold
Gross profit
Iarketing
General and administrative
Depreciation
EBIT
Interest
Earnings before taxes
Income taxes
Net income (loss)
Cash
Accounts receivable
Inventories
Total current assets
Gross fixed assets
Accumulated depreciation
Net fixed assets
Total assets
Accounts payable
Accruals
Bank loan
Total current liabilities
Long-term debt
Common stock (.05 par)
Additional paid-in-capital
Retained earnings
Total liabilities and equity
2018
$900,000 $1,500,000
540,000
360,000
90,000
250,000
40,000
-20,000
45,000
-65,000
0
($65,000)
2018
$50,000
200,000
400,000
650,000
450,000
-100,000
350,000
$130,000
2019
50,000
90,000
270,000
300,000
150,000
200,000
80,000
$1,000,000
900,000
600,000
,000
250,000
40,000
160,000
60,000
100,000
25,000
$75,000
$1,000,000 $1,200,000
2019
$20,000
280,000
500,000
800,000
540,000
-140,000
400,000
$160,000
70,000
100,000
330,000
400,000
150,000
200,000
120,000
$1,200,000
Transcribed Image Text: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 2019.
Book Values
Bank loan
Long-term debt
Common equity
Total
WACC =
Market Values
Bank loan
Long-term debt
Common equity
Total
$ Amount
WACC
100,000
400,000
470,000
970,000
Cindy and Rob estimate that the market value of the common equity in the venture is $900,000 at the end
of 2019. The market values of interest-bearing debt are judged to be the same as the recorded book
values at the end of 2019. Estimate the market value-based weighted average cost of capital for Castillo
Products.
Percent
Weight
$ Amount
After Component
Tax Cost
Cost
5.60%
11.20%
19.00%
Percent
Weight
After
Tax Cost
Component
Cost
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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