Question

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 favourable 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 you approached this calculation. Also, describe the tax shield advantage debt capital provides.

Answer 1

Weighted average cost of capital (WACC) = wd x rd x (1 - tax) + wps x rps + we x re

where, wd - weight of debt = Debt / Total capital = 50 / (50 + 20 + 25) = 52.63%, rd - cost of debt = 5.5%, tax = 30%, wps - weight of preferred stock = Pref. Stock / Total Capita = 20 / (50 + 20 + 25) = 21.05%, rps - cost of preferred stock = 2.75 / 50 = 5.5%, we - weight of equity = 26.32%, re - cost of equity = 12%

=> WACC = 52.63% x 5.5% x (1 - 30%) + 21.05% x 5.5% + 26.32% x 12% = 6.34%

If new debt worth 45m is issued.

wd = (50 + 45) / (95 + 45) = 67.8%, rd = (5.5% x 50 + 45 x 4.5%) / 95 = 5.02%,

wps = 20 / 140 = 14.3% and we = 17.9%

=> New WACC = 5.31%

Tax shield advantage is associated with tax benefit on interest payments on debt.