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

A) Calculation of cuurent cost of capital

Cost of equity= Ke = 12%

Cost of debt = Coupon rate(1-tax rate)

=5.5%(1-0.3)

=5.5%(0.7)

=3.85%

Cost of preference shares = dividend/ price

=2.75/50 = 5.5%

Statement showing WACC

Source of capital	Amount	Weight	K	WACC= Weight*K
Equity	25	26.32%	12%	3.158%
Preference	20	21.05%	5.50%	1.158%
Debt	50	52.63%	3.85%	2.026%
	95			6.342%

B)

If new debt is issued , it's cost will be

=4.5%(1-0.3)

=4.5%*0.7

=3.15%

Statement showing WACC

Source of capital	Amount	Weight	K	WACC= Weight*K
Equity	25	17.86%	12%	2.143%
Preference	20	14.29%	5.50%	0.786%
Debt1	50	35.71%	3.85%	1.375%
Debt2	45	32.14%	3.15%	1.013%
	140			5.316%

WACC is reduced due to debt which has low cost than equity.

By issuing debt , company gets tax benefit , ths cost of debt is effectively reduced by the amount of tax. This reduction is termed as tax shield.