Problem 4-4

Compano inc. was founded in 1986 in Baytown, Texas. The firm provides oil-field services to the Texas Gulf Coast region, including the leasing of drilling barges. Its balance sheet for year-end 2006 describes a firm with 830,541,000 in assets (book values) and invested capital of more than 1.334 billion (based on market values).

December 31, 2006

Liabilities and owners capital Balance sheet Invested Capital

(Book value) (Market values)

Current Liabilities

Accounts Payable 8,250,000

Notes payable 0 0

Other current liabilities 7,266,000

Total current liabilities 15,516,000

Long term debt (8.5% interest paid

Semiannually, due in 2015) 420,000,000 434,091,171

Total liabilities 435,516,000 434,091,171

Owners capital

Common stock ($1 par value per share) 40,000,000

Paid in capital 100,025,000

Accumulated earnings 255,000,000

Total owners capital 395,025,000

Total liabilities and owners capital 830,541,000 1,334,091,171

Companos executive management team is concerned that its new investments be required to meet an appropriate cost of capital hurdle before capital is committed. Consequently, the firms CFO has initiated a cost of capital study by one of his senior financial analysts, Jim Tipolli. Jims first action was to contact the firms investment banker to get input on current capital costs.

Jim learned that although the firms current debt capital required an 8.5% coupon rate of interest (with annual interest payments and no principal repayments until 2015), the current yield on similar debt had declined to 8% if the firm were to raise debt funds today. When he asked about the beta for companos debt, Jim was told that it was standard practice to assume a beta of .30 for the corporate debt of firms such as Compano.

A) What are Companosvcapital structure weights for debt and equity that should be used to compute its cost of capital?

B) Based on Companos corporate income tax rate of 40%, the firms mix of debt and equity financing, and an unlevered beta estimate of .90. What is Companos levered equity beta?

C) Assuming a long term U.S. Treasury bond yield of 5.42% and an estimated market risk premium of 5%, what should Jims estimate of Companos cost of equity be if he uses CAPM?

D) What is your estimate of Companos WACC?