Question

Please discuss the following case study. In doing so, explain your approach to the problem and execute your approach. Provide an answer to the case study’s question with a recommendation.

Case Study:

The Secure and Safe Waste Management Company specializes in handling recyclable materials as well as traditional waste removal services. It is a small but publicly traded corporation. It currently has a capital structure of $50 million in bonds which pay a 5.5% coupon, $20 million in preferred stock with a par value of $50 per share and an annual dividend of $2.75 per share. The company has common stock with a book value of $25 million. The cost of capital associated with the common stock is 12%. The marginal tax rate for the firm is 30%.

The management of the company wishes to acquire additional capital for operations maintenance purposes. The chief financial officer (CFO) suggests that another public debt offering in the amount of $45 million. He believes that because of favorable interest rates, the company could issue the bonds at par with a 4.5% coupon.

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

Calculate the current cost of capital of Secure and Safe on a weighted average basis

Calculate the cost of capital of the company assuming the $45 million dollar bond issue with a 4.5% coupon is approved.

Discuss how your approached this calculation. Also describe the tax shield advantage debt capital provides.

Answer 1

Current Weighted Average cost of Capital can be calculated as follows:

		(A)	(B)	(A)*(B)
Instruement	Amount $	Weight	Cost of Capital	WACC
Bonds	50	52.63%	5.5%*(1-30%) = 3.85%	2.03%
Preferred Stock	20	21.05%	2.75/50 = 5.50%	1.16%
Common stock	25	26.32%	12%	3.16%
	95	100.00%		6.34%

Note 1:

Tax shields refer to the reduction in the tax liability due to the finance cost. Companies have to pay taxes on the profit they made. Finance cost (on loan and mortgages) is a tax deductible expense, which reduces the taxable income. Thus, finance cost act as a ‘shield’ against the tax liability. Hence, the effective cost of debt will be Interest rate * (1 - Tax rate).

Note 2:

Cost of preferred capital can be calculated as : Annual dividend / Par Value of Preferred share

Weighted Average Cost of capital of the company assuming the $45 million dollar bond issue with a 4.5% coupon is approved:

		(A)	(B)	(A)*(B)
Instruement	Amount $	Weight	Cost of Capital	WACC
Bonds	50	35.71%	5.5%*(1-30%) = 3.85%	1.38%
Debt raised via IPO	45	32.14%	4.5%*(1-30%) = 3.15%	1.01%
Preferred Stock	20	14.29%	2.75/50 = 5.50%	0.79%
Common stock	25	17.86%	12%	2.14%
Total	140	100.00%		5.32%

Cost of 'Debt raised via IPO' will be lower than the its coupon on account of tax shield as highlighted in the above calculation.