question archive Case Study The Comic Book Publication Group (CBPG) specializes in creating, illustrating, writing, and printing various publications
Case Study The Comic Book Publication Group (CBPG) specializes in creating, illustrating, writing, and printing various publications
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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 it:
- 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
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Answer:
Cost of capital = 5.44%.
New cost of capital = 4.61%.
Tax shield advantage that debt capital provides:
Tax shield reduces the income tax by providing deductions on the taxable income.
Old bonds:
Value = $12 million
Cost of bonds = 5%
Taxation rate = 33%
Post-tax cost of bonds = 5% * (1 - 0.33) = 3.35%.
Preferred stock:
Value = $5 million
Cost of bonds = 5%
Common stock:
Value = $6 million
Cost of bonds = 10%
Total value = $12 + $5 + $6 = $23
Weight allocated to bond = $12 / $23 = 52.17%.
Weight allocated to preferred stock = $5 / $23 = 21.74%.
Weight allocated to common stock = $6 / $23 = 26.09%.
Cost of capital using weighted average:
(Weight of bonds * Post-tax cost of bond) + (Weight of preferred stock * Cost of preferred stock) + (Weight of common stock * Cost of common stock)
= (0.5217 * 3.35%) + (0.2174 * 5%) + (0.2609 * 10%)
= 5.44%.
Cost of capital on table:
New cost of capital:
Tax shield advantage that debt capital provides:
- Tax shield reduces the income tax by providing deductions on the taxable income.
- As we can see, the cost of debt is considered for the further calculation after the tax deduction of 33% on its 5% cost. Thus, debt capital provides a tax shield to the investor.
Cost of capital is defined as return that is required to make capital budgeting project such as buying a machinery.
Weighted average cost of capital (WACC) is defined as the computation of cost of capital of a firm by allocating proportionate weights to each category of capital in the portfolio. Category of capital includes preferred stocks, bonds, debt, and common stocks.
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