Question

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 1

Weighted Average Cost of Capital or WACC can be defined as that minimum rate of return which renders value creation for a particular firm. This helps the management in understanding the implications of various alternatives to raise capital without incurring heavy costs in the long-run. In the given case scenario, the company, CBPG is considering debt financing through an Initial Public Offering (IPO). As debt financing is a cheaper source of finance, a Debt IPO results in no kind of tax implications as any IPO does not trigger taxation. Taxation only occurs when one sells their shares wherein any gains or losses incurred on sale of such shares is treated as a Capital Gain.

Scenario 1:

The CPBG is a small publicly traded corporation with a current capital structure consisting of:

• 5% Bonds = $12 million
• Preferred Stock (issued at par @ 35 per share) = $5 million
• Total Capital = $12 million + $5 million = $17 million

                As per the given case scenario, the cost of capital for the common stock is 10%. Additionally, the given marginal tax rate for the firm is 33%. While calculating the Cost of Capital on Weighted Average basis, it is important to determine the cost of debt as well as equity. In this case, the cost of debt for the bonds is equivalent to its coupon rate after deducting tax. The rationale behind this is that cost of debt is usually based upon the expenditure incurred by the company, here CBPG, while raising debt. Since the interest on debt is tax-deductible, it is important to take this shield into account while determining the cost of debt for the company. Thus, Cost of Debt for CBPG is 0.0335 (=0.05*(1-0.33)).

Thus, the Current Cost of Capital for CBPG on weighted average basis:

= {(Cost of Debt (After Tax)*Debt/Total Capital) + (Cost of Equity*Equity/Total Capital)}

= {(0.0335*12/17) + (0.10*5/17)}

= {(0.402/17) + (0.5/17)}

= 0.902/17

=0.05305 or 5.31%

Scenario 2:

The CPBG is a small publicly traded corporation with a current capital structure consisting of:

• 5% Bonds = $12 million
• Preferred Stock (issued at par @ 35 per share) = $5 million
• 4% Bonds (issued at par) = $10 million
• Total Capital = $12 million + $5 million + $10 million = $27 million

                As per the given case scenario, the cost of capital for the common stock is 10%. Additionally, the given marginal tax rate for the firm is 33%. Since the CBPG management has decided on raising additional capital in the form of corporate bonds at 4% coupon rate, the company's overall tax-shield has become higher. This is due to the fact that the cost of debt is a cheaper source of raising capita which not only ensures the retention of ownership in the hands of CBPG's management but also provides tax-shield in the form of interest by reducing their overall tax liability.

Thus, New Cost of Debt for CBPG

=0.05*(1-0.33)+0.04*(1-033))

= 0.0335+‭0.017956

= 0.051456 or 5.15%.‬

Thus, the New Cost of Capital for CBPG on weighted average basis:

= {(Cost of Debt (After Tax)*Debt/Total Capital) + (Cost of Equity*Equity/Total Capital)}

= {(0.0335*12/27) + (0.04*10/27) + (0.10*5/27)}

= {(0.402/27) + (0.268/27) + (0.5/27)}

= 1.17/27

=0.0433 or 4.33%