We must now continue to build our models to help explain our financial strategy to the analysts, shareholders and (of course) senior management.

In this task we are examining the current capital structure of ACME Iron and determining the WACC of the company. Assume that ACMEs tax rate is 40%.

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 8% for the firm. Please clearly show how you derive each of these values:

After-tax cost of debt =

Cost of equity =

Proportions of debt and equity in the firm =

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 ACME Iron?

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 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 )

To illustrate and further support our strategic financial planning systems we need to show the CFO and management team an example of the application of the previously constructed WACC. The CFO thinks that showing management how we can validate and choose projects based on expected returns developed from the WACC will help reduce risk of our investors capital thus lowering the required rate of return we would have to provide to those investors. If we lower our expected return we can then do more projects and grow at a faster rate.

He has asked your team to evaluate the following project:

Capital investment: Acme is planning construction of a new loading ramp for its single iron mill. The initial cost of the investment is $1 million. Efficiencies from the new ramp are expected to reduce costs by $100,000 for the life of the plant which is currently estimated at another 30 years. When will this project break-even on a simple cash basis and a discounted cash basis. What is the NPV of the project if Acme has an after tax cost of debt of 8% and a cost equity of 12% (they are currently funded equally by debt and equity)?

ACME Iron		Balance Sheet
Assets
Current assets:	2014	2015	change
Cash	500,000	600,000	100,000
Investments	1,000,000	1,025,000	25,000
Inventories	110,000,000	117,000,000	7,000,000
Accounts receivable	11,750,000	12,500,000	750,000
Pre-paid expenses	2,500,000	2,600,000	100,000
Other	0	0	-
Total current assets	125,750,000	133,725,000	7,975,000
Fixed assets:	2014	2015	change
Property and equipment	165,000,000	175,000,000	10,000,000
Leasehold improvements	0	0	-
Equity and other investments	55,000,000	65,000,000	10,000,000
Less accumulated depreciation	15,000,000	15,500,000	500,000
Total fixed assets	235,000,000	255,500,000	20,500,000
Other assets:	2014	2015	change
Goodwill	75,000,000	70,000,000	-5,000,000
Total other assets	75,000,000	70,000,000	-5,000,000
Total assets	435,750,000	459,225,000	23,475,000
Liabilities and owner's equity
Current liabilities:	2014	2015	change
Accounts payable	40,500,000	42,400,000	1,900,000
Accrued wages	85,000,000	90,500,000	5,500,000
Accrued compensation	10,000,000	10,855,000	855,000
Income taxes payable	4,024,000	4,697,000	673,000
current portion of LT debt	5,500,000	10,350,000	4,850,000
Other	0	0	-
Total current liabilities	145,024,000	158,802,000	13,778,000
Long-term liabilities:	2014	2015	change
Long term debt	125,000,000	130,000,000	5,000,000
Total long-term liabilities	125,000,000	130,000,000	5,000,000
Owner's equity:	2014	2015	change
Common stock	122,000,000	122,000,000	-
Preferred stock	16,725,000	16,725,000	-
Accumulated retained earnings	27,001,000	31,698,000	4,697,000
Total owner's equity	165,726,000	170,423,000	4,697,000
Total liabilities and owner's equity	435,750,000	459,225,000	23,475,000
Income Statement
ACME Iron
Dec-15
Financial Statements in '000s of U.S. Dollars
REVENUE
Gross Sales	250,000
Less: Sales Returns &	2,500
Allowances
Net Sales		247,500
COST OF GOODS SOLD
Beginning Inventory	7,500
Add: Purchases	4,500
Freight-in	-
Direct Labor	75,000
Indirect Expenses	15,000
Inventory Available	102,000
Less: Ending Inventory
Cost of Goods Sold		102,000
Gross Profit (Loss)		145,500
EXPENSES
Advertising	7,500
Amortization	-
Bad Debts	5,000
Depreciation	500
Dues and Subscriptions	-
Employee Benefit Programs	18,750
Insurance	2,500
Interest	10,350
Legal & Professional Fees	100
Licenses & Fees	-
Miscellaneous	10
Office Expenses	100
Payroll Taxes	5,625
Postage	3
Rent	-
Repairs & Maintenance	5,000
Supplies	2,000
Telephone	120
Travel	1,750
Utilities	50,000
Vehicle Expenses	450
Wages	25,000
Total Expenses		134,758
Net Operating Income		10,742
OTHER INCOME
Gain (Loss) on Sale of	-
Assets
Interest Income	1,000
Total Other Income		1,000
TAXES		4,697
Net Income (Loss)		7,045