MINI CASE

The Castillo Products Company was started in 2008. The company manufactures components for personal decision assistant (PDA) products and for other handheld electronic products. A difficult operating year, 2009, was followed by a profitable 2010. The founders (Cindy and Rob Castillo) are interested in estimating their cost of financial capital since they are expecting to secure additional external financing to support planned growth.

Short-term bank loans are available at an 8 percent interest rate. Cindy and Rob believe that the cost of obtaining long-term debt and equity capital will be somewhat higher. The real interest rate is estimated to be 2 percent and a long-run inflation 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; plus 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-firm common stocks over the rate on long-term government bonds is estimated to be 6 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-firm common stocks.

Following are income statements and balance sheets for the Castillo Products Company for 2009 and 2010.

Castillo Products Company

	2020	2021
Net sales	$900,000	$1,500,000
Cost of goods sold	540,000	900,000
Gross profit	360,000	600,000
Marketing	90,000	150,000
General and administrative	250,000	250,000
Depreciation	40,000	40,000
EBIT	-20,000	160,000
Interest	45,000	60,000
Earnings before taxes	-65,000	100,000
Income taxes	0	25,000
Net income (loss)	-$ 65,000	$ 75,000
	2009	2010
Cash	$ 50,000	$ 20,000
Accounts receivable	200,000	280,000
Inventories	400,000	500,000
Total current assets	650,000	800,000
Gross fixed assets	450,000	540,000
Accumulated depreciation	-100,000	-140,000
Net fixed assets	350,000	400,000
Total assets	$1,000,000	$1,200,000
Accounts payable	$ 130,000	$ 160,000
Accruals	50,000	70,000
Bank loan	90,000	100,000
Total current liabilities	270,000	330,000
Long-term debt	300,000	400,000
Common stock (.05 par)	150,000	150,000
Additional paid-in-capital	200,000	200,000
Retained earnings	80,000	120,000
Total liabilities and equity	$1,000,000	$1,200,000

1. Calculate the: net profit margin; total-sales-to-total-assets ratio; the equity multiplier; and the return on equity for both 2020 and 2021 for the Castillo Products Corporation. Describe what happened in terms of financial performance between the two years.

2. Estimate the cost of short-term bank loans, long-term debt, and common equity capital for the Castillo Products Corporation.

3. Although, Castillo Products paid a low effective tax rate in 2021, 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 ventures common equity.

4. 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 2021.

5. Cindy and Rob estimate that the market value of the common equity in the venture is $900,000 at the end of 2021. The market values of interest-bearing debt are judged to be the same as the recorded book values at the end of 2010. Estimate the market value-based weighted average cost of capital for Castillo Products.

6. Would you recommend to Cindy and Rob that they use the book value-based WACC estimate or the market value-based WACC estimate for planning purposes? Why?