4-4 THREE-STEP PROCESS FOR ESTIMATING A FIRM’S WACC, Compano inc. was founded in
ID: 2613331 • Letter: 4
Question
4-4 THREE-STEP PROCESS FOR ESTIMATING A FIRM’S WACC, Compano inc. was founded in 1986 in Baytown, Texas. The firm provides oil-field services to the Texas Gulf Coast region, including the leasing of drilling barges. Its balance sheet for year-end 2006 describes a firm with 830,541,000 in assets (book values) and invested capital of more than 1.334 billion (based on market values).
December 31, 2006
Liabilities and owner’s capital Balance sheet Invested Capital
(Book value) (Market values)
Current Liabilities
Accounts Payable: 8,250,000
Notes payable: 0 0
Other current liabilities: 7,266,000
Total current liabilities: 15,516,000
Long term debt (8.5% interest paid
Semiannually, due in 2015): 420,000,000 434,091,171
Total liabilities: 435,516,000 434,091,171
Owners’ capital
Common stock ($1 par value per share): 40,000,000
Paid in capital: 100,025,000
Accumulated earnings: 255,000,000
Total owners’ capital: 395,025,000
Total liabilities and owners’ capital: 830,541,000 1,334,091,171
Compano’s executive management team is concerned that its new investments be required to meet an appropriate cost of capital hurdle before capital is committed. Consequently, the firm’s CFO has initiated a cost of capital study by one of his senior financial analysts, Jim Tipolli. Jim’s first action was to contact the firm’s investment banker to get input on current capital costs.
Jim learned that although the firm’s current debt capital required an 8.5% coupon rate of interest (with annual interest payments and no principal repayments until 2015), the current yield on similar debt had declined to 8% if the firm were to raise debt funds today. When he asked about the beta for compano’s debt, Jim was told that it was standard practice to assume a beta of .30 for the corporate debt of firms such as Compano.
A) What are Compano’s capital structure weights for debt and equity that should be used to compute its cost of capital?
B) Based on Compano’s corporate income tax rate of 40%, the firm’s mix of debt and equity financing, and an unlevered beta estimate of .90. What is Compano’s levered equity beta?
C) Assuming a long term U.S. Treasury bond yield of 5.42% and an estimated market risk premium of 5%, what should Jim’s estimate of Compano’s cost of equity be if he uses CAPM?
D) What is your estimate of Compano’s WACC?
Explanation / Answer
Answer-A:
For computation of its cost of capital , we should use market value weights :
Market value of Debt = 434,091,171
Market value of equity = 1,334,091,171- 434,091,171 = $900,000,000
Hence Weight for Debt = 434091171 / 1334091171 = 32.54%
Hence Weight for Equity = $900,000,000 / 1334091171 = 67.46%
Answer-B:
Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))
=0.90*(1 + ((1 – 40%) x (32.54/67.46)))
=0.90*(1 + (0.6 x 0.482359917))
=0.90*(1 + 0.28941595)
= 1.16
Answer-C:
Calculation of Cost of Equity using CAPM :
Cost of Equity = Risk free rate + (beta * market rate premium)
=5.42% + (0.90*5%)
= 9.92%
Answer-D:
WACC = Cost of Equity * weight of Equity + Cost of debt * weight of Debt
= 9.92 *67.46% + [8.5 *(1-40%)*32.54%]
= 6.69 + 1.66
= 8.35 %
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