Chapter 7: Typos und Costs of Financial Capital 261 MINICASE Castillo Products Company The Castila Products Company was started in 2014. The company manufactures components for personal digital assistant IPDA products and for other handheld electronic products. A difficult Operating year, 2015, was followed by a profitable 2016. The founders (Ondy and Rob Castillo are interested in estimating their cost of financial capital because they are expecting to secure additional extemal francing to support planned growth Short-term bank loons are available at an 8 percent interest rate. Cindy and Pob beleve that the cost of obtaining long- term debt and equity capital will be somewhat higher. The real interest rate is estimated to be percent, and a long-tunina tion premium is estimated at 3 percent. The interest rate on long-term government bonds is 7 percent A default-risk premium on long-term debt is estimated at 6 percent pus Castillo Products is expecting to have to pay a liquidity premium of 3 percent due to the illiquidity associated with its long-term debt. The market risk premium on large-fom common stocks over the rate on long-term government bonds is estimated to be 5 percent. Cindy and Rob expect that equity investors in their venture will require an additional investment risk premium estimated at two times the market risk premium on large-fem common stocks. Following are income statements and balance sheets for the Castillo Products Company for 2015 and 2016. CASTILLO PRODUCTS COMPANY 2015 $ 900.000 INCOME STATEMENT Net sales Cost of goods sold Gross profit Marketing General and administrative Deprecision EBIT West Eamnings before taxes Income taxes Not income si SCO 250.000 40.000 -20.000 45.000 -85.000 2016 $1.500.000 900,00 800.00 150,000 250,000 40.000 160.000 80,000 100.000 25.000 $75.000 $ 6.000 2015 50.000 2016 $ 20,000 $ BALANCE SHEET Cash Asocible Inventories Total antes Gross fixed assets Acumulated sereciation Nered assets Toral sets A pays 40 cm 550.000 450.000 900.000 300000 540,000 -10000 -100 400 000 $1.200.000 $190.000 1 BC.000 $ 130,000 30,000 90.000 270.000 300,000 Bank loon Toral contes Longternet Common to SC. per Additional peonata Retained in zero 130.000 200.000 120.000 $1200000 51.000.000 (continued on next page) Castillo Products Company (Continued) A Calculate the net profit margin, total-sales-to-total-assets ratio, the equity multiplier, and the return on equity for both 2015 and 2016 for the Castillo Products Corporation Describe what happened in terms of financial performance between the two years B. Estimate the cost of short-term bank loans long-term dett, and common equity capital for the Castillo Products Corporation C. Although, Castillo Products paid a low effective tax rate in 2016. a 30 percent income tax rate is considered more appropriate when looking to the future. Estimate the after-tax cost of short-term bank loans, long-term debt, and the venture's common equity. D. Estimate the weighted average cost of capital (WACC) for the Castillo Products Corporation using the book values of interest-bearing debt and stockholders' equity capital at the end of 2016. E Cindy and Rob estimate that the market value of the common equity in the venture is $900.000 at the end of 2018 The market values of interest-bearing debt are judged to be the same as the recorded book values at the end of 2016. Estimate the market value-based weighted average cost of capital for Castilo Products F. Would you recommend to Cindy and Rob that they use the book value bosed WACC estimate or the market value based WACC estimate for planning purposes? Why? MINICASE Castillo Products Company The Castillo Products Company was started in 2014. The company manufactures components for personal digital assistant IPDA products and for other handheld electronic products. A difficult Operating yow, 2015, was followed by a profitable 2015. The founders (Oncy and Rob Custo se interested in estimating the cost of financial capital because they are expecting to secure additional external francing to support planned growth Short-term bank loans are available of an percent interest rate. Cindy and Rob beleve that the cost of obtaining long term debt and equity capital will be somewhat higher. The real interest rate is estimated to be percent, and a long-run infa- tion premium is estimated at 3 percent. The interest rate on long-term government bonds 7 percent. A default-risk premium on long-term debt is estimated at 6 percent plus Castillo Products is expecting to have to pay a liquidity premium of 3 percent dun to the illiquidity associated with its long-term debt. The market nsk premium on large firm common stocks over the rate on long-term government bonds is estimated 10 o 6 percent. Cindy and Rob expect that equity investors in their venture will Tequire an additional investment risk premium estimated at two times the market risk premium on large-firm common stocks Following are income statements and balance sheets for the Castillo Products Company for 2015 and 2016 CASTILLO PRODUCTS COMPANY INCOME STATEMENT 2018 2015 S SOC.DOC $1.500 Cost of goods sold B profit Marketing General and administrative Depreciation EBIT inte Lamings Before taxes Income taxes Net income possi 3560 SCO 250 DCC 40 -20.000 45.000 -65.000 90 500 000 150 DOC 250.00C 40 C 160 000 100.DOC 250C $ 55.000 $ 75 DOC BALANCE SHEET 2015 2016 $ 20.000 Account cele Inventaries Total contes Gross fundata Actunulated deretition Not find asset Total About payable Athuis Banken Total curent l es Long torn det Common stock para Additional incat Retained ning Torallabies and equity 200.000 .. 550.000 430.000 - 100.000 350.000 $1.000.000 $ 130 000 50000 300.000 50.000 -140.000 400.000 $1.200.000 $ 1600 70.000 22000 300 on 150C 400.000 130.000 80 000 $1.200.000 (continued on next page) 262 Part 3 Planning for the Future Castillo Products Company (Continued) A. Calculate the net profit margin, total-sales-to-total-assets ratio, the equity multiplier, and the return on equity for both 2015 and 2016 for the Castilo Products Corporation. Describe what happened in terms of financial performance between the two years. 8. Estimate the cost of short-term bank loans, long-term debt, and common equity capital for the Castillo Products Corporation C. Although. Castillo Products paid a low effective tax rate in 2016. a 30 percent income tax rate is considered more appropriate when looking to the future. Estimate the after-tax cost of short-term bank loans long-term dett, and the venture's common equity. D. Estimate the weighted average cost of capital (WACC) for the Castilo Products Corporation using the book values of interest-bearing debt and stockholders' equity capital at the end of 2016. E. Cindy and Rob estimate that the market value of the common equity in the venture is $900.000 at the end of 2018 The market values of interest-boring debt are judged to be the same as the recorded book values at the end of 2016. Estimate the market value-based weighted average cost of capital for Castillo Products F. Would you recommend to Cindy and Rob that they use the book value-based WADC estimate or the market value based WACC estimate for planning purposes? Why