Cape Cod Lobster Shacks, Inc. (CCLS) is a seafood restaurant chain operating thr

Question

Cape Cod Lobster Shacks, Inc. (CCLS) is a seafood restaurant chain operating throughout the northeast. The company has two sources of long-term capital: debt and equity. The cost to CCLS of issuing debt is the after-tax cost of the interest payments on the debt, taking into account the fact that the interest payments are tax deductible. The cost of CCLS’s equity capital is the investment opportunity rate of CCLS’s investors, that is, the rate they could earn on investments of similar risk to that of investing in Cape Cod Lobster Shacks, Inc. The interest rate on CCLS’s $80 million of long-term debt is 9 percent, and the company’s tax rate is 40 percent. The cost of CCLS’s equity capital is 14 percent. Moreover, the market value (and book value) of CCLS’s equity is $120 million.

Cape Cod Lobster Shacks, Inc. consists of two divisions, the properties division and the food service division. The divisions’ total assets, current liabilities, and before-tax operating income for the most recent year are as follows:

Weighted-average cost of capital is 10.56%

1. Calculate the weighted-average cost of capital for Cape Cod Lobster Shacks, Inc.

Division Total Assets Current Liabilities Before-Tax Operating Income Properties $145,000,000 $3,000,000 $29,000,000 Food Service $64,000,000 $6,000,000 $15,000,000

Explanation / Answer

1)After tax cost of debt = 9(1-.40 tax)

                   = 9*.60

                    = 5.4%

Market value (millions) Market value weights cost weighted average cost of capital After tax cost of Debt 80 80/200= .40 5.40 5.40*.40=2.16   [5.4*.40] cost of equity 120 120/200= .60 14 14*.60=8.4      [14*.60] 200 weighted-average cost of capital 10.56%   [2.16+8.4]

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