Case Study:

The Comic Book Publication Group (CBPG) specializes in creating, illustrating, writing, and printing various publications. It is a small but publicly traded corporation. CBPG currently has a capital structure of $12 million in bonds that pay a 5% coupon, $5 million in preferred stock with a par value of $35 per share and an annual dividend of $1.75 per share. The company has common stock with a book value of $6 million. The cost of capital associated with the common stock is 10%. The marginal tax rate for the firm is 33%.

The management of the company wishes to acquire additional capital for operations purposes. The chief executive officer (CEO) and chief financial officer (CFO) agree that another public debt offering (corporate bonds) in the amount of $10 million would suffice. They believe that due to favorable interest rates, the company could issue the bonds at par with a 4% coupon.

Before the Board of Directors convenes to discuss the debt Initial Public Offering (IPO), the CFO wants to provide some data for the board of directors’ meeting notebooks. One point of the analysis is to evaluate the debt offering’s impact on the company’s cost of capital. To do this:

 

• Solve for the current cost of capital of CBPG on a weighted average basis
• Solve for the new cost of capital, assuming the $10 million bond issued at par with a 4% coupon.
• Describe how you approached these calculations. Also discuss the tax shield advantage that debt capital provides, and briefly explain the cost of capital and WACC
• Provide a Table(s) to present answers (Students can transfer their EXCEL Table if utilized)

 

Summarize findings

Superior papers will explain the following elements when responding to the assignment questions:

 

• Provide narrative and solve for the current cost of capital of CBPG on a weighted average basis (WACC)
• Provide narrative and solve for the new cost of capital (WACC)
• Provide accurate WACC calculations for both scenarios
• Provide a Table(s) to present answers (there is a difference between performing calculations and presenting the supporting data and solved answers)
• Provide narrative on tax shield implications for both scenarios
• Provide narrative briefly explaining the cost of capital and WACC
• Provide a clear, logical conclusion

Answer:

Provide narrative and solve for the current cost of capital of CBPG on a weighted average basis (WACC)

The capital structure (sources of funds) of a firm will have various components in it. The three main components of capital are: Equity share (Common equity), Preference Share (preferred Stock) and Debt (Bank loan, Debenture or Bonds). Each of these components has different features, advantages and disadvantages and hence they offer a different perception of risk and return in the mind of investors. Since they have different risk and return profile, they have different cost (or expected return) associated with them. A cost of capital is sum total of cost of individual components in the capital structure of the firm.

Weighted average cost of capital (“WACC”) is that average cost of capital which when applied on the total capital deployed by the firm, gives the same cost to the firm as sum of the cost of the individual components in the capital. WACC reflects the average risk of projects that make up the firm.

WACC = Wd x Kd x (1 - T) + Ws x Ks + We x Ke

Current cost of capital:

All the cost of capital should be after tax cost if that cost is tax deductible. Since, interest is tax deductible hence it should be after tax cost of debt. As dividends or any other forms of return on equity are not tax deductible, they should be applied at their pre tax rate.

Please see the table below:

Hence, the current cost of capital of CBPG on a weighted average basis (WACC) = 5.44%

Provide narrative and solve for the new cost of capital (WACC)

We will follow the similar approach as before but this time we will include the new debt also. Please see the table below:

Provide accurate WACC calculations for both scenarios - Answered in the table above
Provide a Table(s) to present answers (there is a difference between performing calculations and presenting the supporting data and solved answers) - Answered in the table above

Provide narrative on tax shield implications for both scenarios

Interest is tax deductible. Hence, interest expenses lead to reduction in taxes to be paid. They are therefore said to offer a tax shield. Higher the quantum of debt, higher will be the tax shield offered (assumption: debt is at normal level and hence doesn't lead to cost of financial distress and bankruptcy). Since, debt levels are higher after the incremental debt, the interest tax shield will also be higher under the new scenario.

Provide narrative briefly explaining the cost of capital and WACC

A lot has been written about this at the beginning of the answer. Please use them.

Provide a clear, logical conclusion

In the new scenario:

• The proportion of debt in the capital structure is higher
• Cost of debt is lower than the cost of equity
• Interest is tax deductible. Hence, post tax cost of debt is even lower
• Hence, the firm has lower cost of capital / WACC under the new scenario.
• The firm is therefore better off by issuing debt in this case.