Capital Structure and Weighted Average Cost of Capital:

In this task, we are examining the current capital structure of BEB and determine the WACC of the company. Assume that BEBs tax rate is 36%.

To compute the WACC you must first find the after-tax cost of debt, the cost of equity, and the proportions of debt and equity in the firm. You can assume that the cost of debt before tax is 7.5% for the firm. Please clearly show how you derive each of these values:

The after-tax cost of debt =

Cost of equity = (from your previous task)

Proportions of debt and equity in the firm (from the balance sheet) =

How do we compute the WACC in this circumstance? Why do we need to be concerned with the WACC?

Any insights into the capital structure of BEB ?

Concept Check: Capital structure for a public company consists of both debt and equity. We must take into account the ability to write off interest payments in the calculation of our cost of debt which results in an after-tax cost of debt being used in our WACC calculation.

The weighted average cost of capital is the weighted average of the cost of equity and the after-tax cost of debt. Another way of looking at this is by computing the effect of the capital structure on expected returns by investors.

WACC= (S/(B+S) x Rs) + (B/(B+S) x R_B x (1 t_c))

Where

S = value of equity

B = value of debt

Rs = cost of equity

After tax cost of debt: R_B x (1 t_c )

Helpful Hint: One thing to bring up here is WACC is needed to determine risk on several levels. To determine risk we need to remember the following items:

Risk is a deviation from expectations.

We need to set expectations for our investments based on risk and return. Higher risk = higher return.

Capital is obtained from the marketplace in two forms; equity and debt. This is the capital structure of a corporation and impacts the profits of a company depending on how this is managed.

We use our cost of capital to discount any cash flows from new investments (NPV and IRR analysis).

If the cost of capital rises then our risk rises and the projects we undertake to increase sales and return to our investors are reduced.

If debt rises then our obligation to make payments on interest increases and profits can decrease if sales do not increase rapidly enough.

If risk increases our beta will increase to show the increase in risk. This will increase our required rate of return to stockholders (CAPM) and thus increase our required rate of return we must use in discounting future cash flows.

BEB Balance Sheet Assets \begin{tabular}{llll} \hline Fixed assets: & 2020 & 2021 & \multicolumn{1}{c}{ change } \\ \hline Property and equipment & 155,000,000 & 172,500,000 & 17,500,000 \\ \hline Leasehold improvements & 0 & 0 & 0 \\ \hline Equity and other investments & 48,000,000 & 57,000,000 & 9,000,000 \\ \hline Total fixed assets & 203,000,000 & 229,500,000 & 26,500,000 \end{tabular} \begin{tabular}{llll} \hline Other assets: & 2020 & 2021 & change \\ \hline Goodwill & 85,000,000 & 70,000,000 & 15,000,000 \\ \hline Total other assets & 85,000,000 & 70,000,000 & 15,000,000 \end{tabular} Total assets 416,950,000444,475,000 27,525,000 Liabilities and owner's equity \begin{tabular}{llll} \hline Current liabilities: & 2020 & 2021 & \multicolumn{1}{l}{ change } \\ \hline Accounts payable & 38,500,000 & 43,200,000 & 4,700,000 \\ \hline Accrued wages & 75,000,000 & 80,500,000 & 5,500,000 \\ \hline Accrued compensation & 10,000,000 & 10,255,000 & 255,000 \\ \hline \end{tabular} \begin{tabular}{llll} Income taxes payable & 4,024,000 & 4,697,000 & 673,000 \\ \hline current portion of LT debt & 5,000,000 & 5,350,000 & 350,000 \\ \hline Other & 0 & 0 & 0 \\ \hline Total current liabilities & 132,524,000 & 144,002,000 & 11,478,000 \end{tabular} \begin{tabular}{llll} \hline Long-term liabilities: & 2020 & 2021 & change \\ \hline Long term debt & 115,000,000 & 130,000,000 & 15,000,000 \\ \hline Total long-term liabilities & 115,000,000 & 130,000,000 & 15,000,000 \end{tabular} \begin{tabular}{llll} Owner's equity: & 2020 & 2021 & change \\ \hline Common stock & 122,000,000 & 122,000,000 & 0 \\ \hline Preferred stock & 16,725,000 & 16,725,000 & 0 \\ \hline Accumulated retained earnings & 30,701,000 & 31,748,000 & 1,047,000 \\ \hline Total owner's equity & 169,426,000 & 170,473,000 & 1,047,000 \\ \hline \end{tabular} Total liabilities and owner's equity 416,950,000444,475,000 27,525,000 Income Statement BEB December 2021 Financial Statements in 'o00s of U.S. Dollars Revenue Gross Sales Less: Sales Returns and Allowances Net Sales \begin{tabular}{|r|r|} \hline 282,000 & \\ \hline 2,500 & \\ \hline & 279,500 \\ \hline \end{tabular} Cost of Goods Sold Beginning inventory Add: Purchases Freight-in Direct Labor Indirect Expenses Inventory Available Less: Ending Inventory Cost of Goods Sold Gross Profit (Loss) Net Operating Income Other Income Gain (Loss) on Sale of Assets Interest Income Total Other Income Taxes Net Income (Loss) BEB Balance Sheet Assets \begin{tabular}{llll} \hline Fixed assets: & 2020 & 2021 & \multicolumn{1}{c}{ change } \\ \hline Property and equipment & 155,000,000 & 172,500,000 & 17,500,000 \\ \hline Leasehold improvements & 0 & 0 & 0 \\ \hline Equity and other investments & 48,000,000 & 57,000,000 & 9,000,000 \\ \hline Total fixed assets & 203,000,000 & 229,500,000 & 26,500,000 \end{tabular} \begin{tabular}{llll} \hline Other assets: & 2020 & 2021 & change \\ \hline Goodwill & 85,000,000 & 70,000,000 & 15,000,000 \\ \hline Total other assets & 85,000,000 & 70,000,000 & 15,000,000 \end{tabular} Total assets 416,950,000444,475,000 27,525,000 Liabilities and owner's equity \begin{tabular}{llll} \hline Current liabilities: & 2020 & 2021 & \multicolumn{1}{l}{ change } \\ \hline Accounts payable & 38,500,000 & 43,200,000 & 4,700,000 \\ \hline Accrued wages & 75,000,000 & 80,500,000 & 5,500,000 \\ \hline Accrued compensation & 10,000,000 & 10,255,000 & 255,000 \\ \hline \end{tabular} \begin{tabular}{llll} Income taxes payable & 4,024,000 & 4,697,000 & 673,000 \\ \hline current portion of LT debt & 5,000,000 & 5,350,000 & 350,000 \\ \hline Other & 0 & 0 & 0 \\ \hline Total current liabilities & 132,524,000 & 144,002,000 & 11,478,000 \end{tabular} \begin{tabular}{llll} \hline Long-term liabilities: & 2020 & 2021 & change \\ \hline Long term debt & 115,000,000 & 130,000,000 & 15,000,000 \\ \hline Total long-term liabilities & 115,000,000 & 130,000,000 & 15,000,000 \end{tabular} \begin{tabular}{llll} Owner's equity: & 2020 & 2021 & change \\ \hline Common stock & 122,000,000 & 122,000,000 & 0 \\ \hline Preferred stock & 16,725,000 & 16,725,000 & 0 \\ \hline Accumulated retained earnings & 30,701,000 & 31,748,000 & 1,047,000 \\ \hline Total owner's equity & 169,426,000 & 170,473,000 & 1,047,000 \\ \hline \end{tabular} Total liabilities and owner's equity 416,950,000444,475,000 27,525,000 Income Statement BEB December 2021 Financial Statements in 'o00s of U.S. Dollars Revenue Gross Sales Less: Sales Returns and Allowances Net Sales \begin{tabular}{|r|r|} \hline 282,000 & \\ \hline 2,500 & \\ \hline & 279,500 \\ \hline \end{tabular} Cost of Goods Sold Beginning inventory Add: Purchases Freight-in Direct Labor Indirect Expenses Inventory Available Less: Ending Inventory Cost of Goods Sold Gross Profit (Loss) Net Operating Income Other Income Gain (Loss) on Sale of Assets Interest Income Total Other Income Taxes Net Income (Loss)