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The Castillo Products Company was started in 2017. The company manufactures components for personal decision assistant (PDA) products and for other handheld electronic products. A difficult operating year, 2018, was followed by a profitable 2019. 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 2018 and 2019.

The Castillo Products Company was started in 2017. The company manufactures components for personal decision assistant (PDA) products and for other handheld electronic products. A difficult operating year, 2018, was followed by a profitable 2019. 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 2018 and 2019.

Essentials Of Investments
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
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Mini Case The Castillo Products Company was started in 2017. The company manufactures components for personal decision assistant (PDA) products and for other handheld electronic products. A difficult operating year, 2018, was followed by a profitable 2019. 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 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 2018 and 2019. Castillo Products Company Net sales Cost of goods sold Gross profit Iarketing General and administrative Depreciation EBIT Interest Earnings before taxes Income taxes Net income (loss) Cash Accounts receivable Inventories Total current assets Gross fixed assets Accumulated depreciation Net fixed assets Total assets Accounts payable Accruals Bank loan Total current liabilities Long-term debt Common stock (.05 par) Additional paid-in-capital Retained earnings Total liabilities and equity 2018 $900,000 $1,500,000 540,000 360,000 90,000 250,000 40,000 -20,000 45,000 -65,000 0 ($65,000) 2018 $50,000 200,000 400,000 650,000 450,000 -100,000 350,000 $130,000 2019 50,000 90,000 270,000 300,000 150,000 200,000 80,000 $1,000,000 900,000 600,000 ,000 250,000 40,000 160,000 60,000 100,000 25,000 $75,000 $1,000,000 $1,200,000 2019 $20,000 280,000 500,000 800,000 540,000 -140,000 400,000 $160,000 70,000 100,000 330,000 400,000 150,000 200,000 120,000 $1,200,000
Transcribed Image Text:Mini Case The Castillo Products Company was started in 2017. The company manufactures components for personal decision assistant (PDA) products and for other handheld electronic products. A difficult operating year, 2018, was followed by a profitable 2019. 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 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 2018 and 2019. Castillo Products Company Net sales Cost of goods sold Gross profit Iarketing General and administrative Depreciation EBIT Interest Earnings before taxes Income taxes Net income (loss) Cash Accounts receivable Inventories Total current assets Gross fixed assets Accumulated depreciation Net fixed assets Total assets Accounts payable Accruals Bank loan Total current liabilities Long-term debt Common stock (.05 par) Additional paid-in-capital Retained earnings Total liabilities and equity 2018 $900,000 $1,500,000 540,000 360,000 90,000 250,000 40,000 -20,000 45,000 -65,000 0 ($65,000) 2018 $50,000 200,000 400,000 650,000 450,000 -100,000 350,000 $130,000 2019 50,000 90,000 270,000 300,000 150,000 200,000 80,000 $1,000,000 900,000 600,000 ,000 250,000 40,000 160,000 60,000 100,000 25,000 $75,000 $1,000,000 $1,200,000 2019 $20,000 280,000 500,000 800,000 540,000 -140,000 400,000 $160,000 70,000 100,000 330,000 400,000 150,000 200,000 120,000 $1,200,000
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 2019. Book Values Bank loan Long-term debt Common equity Total WACC = Market Values Bank loan Long-term debt Common equity Total $ Amount WACC 100,000 400,000 470,000 970,000 Cindy and Rob estimate that the market value of the common equity in the venture is $900,000 at the end of 2019. The market values of interest-bearing debt are judged to be the same as the recorded book values at the end of 2019. Estimate the market value-based weighted average cost of capital for Castillo Products. Percent Weight $ Amount After Component Tax Cost Cost 5.60% 11.20% 19.00% Percent Weight After Tax Cost Component Cost 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
Transcribed Image Text: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 2019. Book Values Bank loan Long-term debt Common equity Total WACC = Market Values Bank loan Long-term debt Common equity Total $ Amount WACC 100,000 400,000 470,000 970,000 Cindy and Rob estimate that the market value of the common equity in the venture is $900,000 at the end of 2019. The market values of interest-bearing debt are judged to be the same as the recorded book values at the end of 2019. Estimate the market value-based weighted average cost of capital for Castillo Products. Percent Weight $ Amount After Component Tax Cost Cost 5.60% 11.20% 19.00% Percent Weight After Tax Cost Component Cost 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
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