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

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.

 

 

 

The current cost of Capital of Secure and Safe on a Weighted average basis

 

Cost of Debt –

The company currently has $50 in bonds which pay a 5.5% coupon

Applicable tax rate – 30%

So cost of the debt is = 0.055(1 – 0.3) = 0.0385 or 3.85%

The cost of this debt is less because of the tax shield. Interest expenses are tax-deductible for the company (Folger, 2018). In other words, the company pays $2,750,000 in coupon payment. The company can save 30% of interest paid in tax payment, or $825,000 is saved in tax, and that reduces the cost of capital for this bond.

Cost of Preferred Cost –

The company has $20 million in preferred stock of par value $50 which pays $2.75 per share

Cost of preferred stock = 2.75 / 50 = 0.055 = 5.5%

Preferred stocks are both equity and debt component. There is no upside for the investor but the dividend payout is consistent. For the company, there is no tax benefit on dividend payout though, on $20 million preferred stocks the company hands out $1,100,000 but there is no tax break for it.

Cost of Common stock –

The company has common cost worth $25 million and cost of capital is 12%

 

Total market value of working capital = 50 + 20 +25 = $95 million

We add up the bond, preferred stocks and common stocks, and then find out the percentage of each type of funding.

Percentage of bond = 50/95 = 52.63%

Percentage of preferred stocks = 20/95 = 21.05%

Percentage of common stocks = 25/95 = 26.32 %

So, WACC

(0.5263)*(0.0385) + (0.2105)(0.055) + (0.2632) (.12) =    0.02026255+ 0.0115775+ 0.031584 = 0.06342405 = 6.34%

We get the WACC by multiplying the cost of capital and percentage of each capital type and then add all of them.

 

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

 

We already have the cost of capitals for previous capital types, we need to find the capital cost for the $45 million, which it wants to issue.

Now if this bond is issued, cost of the bond will be –

0.045(1 – 0.3) = 0.0315 or 3.15% because the interest payment will be tax deductible for the company, that will reduce the effective cost of new capital.

The process to calculate remains same, but the total capital will go up as the $45 million will be added.

With the new $45 bond the total market value of working capital = 50 + 20 +25 +45 = $140 million

Percentage of bond paying 5.5% coupon= 50/140 = 35.71%

Percentage of preferred stocks = 20/140 = 14.29%

Percentage of common stocks = 25/140 = 17.86%

Percent of bond paying 4.5% coupon = 45/140 = 32.14%

With the new $45 bond the WACC will be

(0.3571)(0.0385) + (0.1429)(0.055) + (0.1786) (.12) + (0.3214) (0.0315)  = .01374835 + .0078595 + 0.021432 + .0101241 = 0.05316395 or 5.32%

Cost of capital is multiplied with the percentage weight of the capital and then adding all of them.

 

Reference –

Folger, J ( April 2018). What Is The Formula For Calculating Weighted Average Cost Of Capital (WACC)?. Retrieved from https://www.investopedia.com/ask/answers/063014/what-formula-calculating-weighted-average-cost-capital-wacc.asp

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