Question

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 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

The weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted.

Formula for calculation of WACC

WACC = Weight of Bonds * Cost of Debt *(1-Corporate Tax rate) + Weight of Preferred Stock * Cost of Preferred Stock + Weight of Common Stock * Cost of Common Stock

CBPG has bonds, preferred stock and common stock in its capital structure.

Calculation of weights of each capital structure.

	Amount (in millions)	Weights*
Bonds	$12	52.2%
Preferred Stock	$5	21.7%
Common Stock	$6	26.1%
Total	$23	100%

* Formula for calculation of weights = Amount of particular capital / Total Capital

E.g - Weight of Bonds = 12/23 = 52.2%, in same manner weights of preferred stock and common stock has been calculated.

Cost of Bonds and Common stock is given as 5% and 10%

Cost of Preferred stock can be calculated based on par value and dividend amount given

Par value of preferred stock is $35 and Dividend per share is $1.75

Cost of Preferred stock = 1.75 / 35 = 5%

Based on above information lets calculate WACC

Part A - WACC

WACC = Weight of Bonds * Cost of Bond *(1-Corporate Tax rate) + Weight of Preferred Stock * Cost of Preferred Stock + Weight of Common Stock * Cost of Common Stock

= 52.2% * 5% *(1-33%) + 21.7% * 5% + 26.1% * 10%

=1.75% + 1.09% + 2.61%

=5.44%

Part B WACC when company plans to raise more funds of $10 million at 4% via issuing of bonds

Calculation of weights of each capital structure.

	Amount (in millions)	Weights
Bonds	$12	36.4%
Preferred Stock	$5	15.2%
Common Stock	$6	18.2%
New Bonds	$10	30.3%
Total	$33	100%

WACC = Weight of Bonds * Cost of Debt *(1-Corporate Tax rate) + Weight of New Bonds * Cost of New Bond *(1-Corporate Tax rate) + Weight of Preferred Stock * Cost of Preferred Stock + Weight of Common Stock * Cost of Common Stock

= 36.4% * 5% * (1-33%) + 30.3% * 4% * (1-33%) + 15.2% * 5% + 18.2% * 10*

= 1.22% + 0.81% + 0.76% + 1.82%

= 4.61%

Part C - Lets understand tax shield which debt capital provides

For this lets consider two companies A and B

Company A with Debt of $100000 at 5% coupon (Annual Interest - $5000)

Company B has no Debt in its books

Both companies are similar on basis of business and financials

Example

Particulars	Company A	Company B
EBIT	100000	100000
Interest	5000	0
EBT	95000	100000
Tax (33%)	31350	33000
EAT	63650	67000

From the above table it can be easily seen that Company A has paid less amount of tax amount by $1650 compared to Company B which is nothing but 5000 * 33% which means company who has debt in its books gets tax advantage. So for calculation of WACC also we consider same