MGF 301 Lecture Notes - Lecture 1: Legal Personality, Investment Banking, Capital Expenditure
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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?