St. Louis Chemical: cost of capital.(Instructor's Note)
The primary subject matter of this case concerns the issues surrounding a firm's weighted average cost of capital (WACC). Case provides a review of cost of capital issues. The case requires students to have knowledge of accounting and finance, thus the case has a difficulty level of three (junior level) or higher. The case is designed to be taught in one class session of approximately 1.25 hours and is expected to require 2-3 hours of preparation time from the students.
The case tells the story of Don Williams, President and primary owner of St. Louis Chemical. By most measures, the performance of St. Louis Chemical has been very good over the last three years, with sales and income increasing each year Business growth has been steady but a recent increase in demand has placed a strain on existing operations. To keep pace with demand, the capacity of the current warehouse and packaging operations need to be increased. The cost of the facility expansion has been estimated to be $900,000 by St. Louis Chemical's operation manager.
Since beginning operations, Williams has been reluctant to borrow funds. He has been content with limited growth, financed with internally generated equity.
Recently hired Edison Hesselbach, the company's first finance professional, has recommended borrowing the required funds. Williams indicated he may be willing to consider a change in his long-standing policy against debt, but wants more information regarding using debt in the firm's capital structure.
The case as written includes discussion questions to aid the student in their analysis of St. Louis Chemical's current situation. The case can be made more difficult by omitting the discussion questions.
As the case opened Don Williams, the President of the St. Louis Chemical, a regional chemical distributor, headquartered in St. Louis, Missouri, is in need of additional assets and financing to support future growth. To keep pace with demand, the capacity of the current warehouse and packaging operations need to be increased. The cost of the facility expansion has been estimated to be $900,000 by St. Louis Chemical's operation manager.
Williams has also followed a conservative financing policy. Since beginning operations, he has been reluctant to borrow funds, content with limited growth, financed with internally generated equity. The only long-term debt on the company's balance sheet reflects the financing associate with vehicles. If the facility is to be expanded, additional external financing will be necessary. St. Louis Chemical's income statement and balance sheet for the years 2007-2009 are provided in Schedules One and Two, respectively.
Hesselbach has recommended borrowing the required funds. Williams indicated he may be willing to consider a change in his long-standing policy against debt, but wants more information regarding the advantages of using debt in the firm's capital structure.
Hesselbach, using input from an investment-banking firm, has estimated the company's cost of equity to be 14%. A St. Louis bank has indicated a long-term bank loan can be arranged to finance expansion at an annual interest rate of 10%. The bank would require either loan to be secured with expansion and other company assets. The loan agreement would also include a number of restrictive covenants, including a limitation of dividends while the loans are outstanding. Only a small amount of long-term debt is included in the firm's current capital structure, the firm's debt ratio at the end of 2009 was 21% and long-term debt was only .28% of total assets (see schedule 2). Hesselbach calculated that if a long-term bank loan was used to obtain the needed $900,000, the firm's debt ratio would increase to 30%. He believes a 30% debt and 70% equity capital mix would be conservative and a starting point for introducing long-term debt into the firm's capital structure. Last year the company's federal-plus-state income tax rate was 35%. Hesselbach does not expect the income tax rate to change in the foreseeable future.
1 Prepare a presentation for Williams regarding the concept of a firm's weighted average cost of capital (WACC).
Simply stated the weighted average cost of capital WACC is the cost the company is paying to finance its assets. As its name indicates, it is a weighted average of the costs of the various sources of capital (debt and equity) used in the firm's capital structure. What is not so readily apparent by its name is that the WACC is an after-tax cost. In other words, it is calculated using the after-tax cost of each source of capital. Interest paid by a business is tax deductible, thus the cost of debt needs to be converted to an after-tax cost by multiplying the before-tax interest rate by one minus the firm's marginal income tax rate. The firm's WACC is also referred to as the firm's marginal cost of capital or what a firm must pay for its next dollar of capital. Another point that should be made is since the WACC is used by businesses to evaluate possible long-term expenditures (capital projects) only long-term capital sources are included in the calculation. Thus, most firms do not include the cost of short-term debt in the calculation.
To determine WACC a firm must 1) calculate the cost it must pay for each source of capital and 2) determine the target mix of debt and equity to be used by the firm. The cost of each source of capital and the target capital structure are provided in the case. St. Louis Chemical's before-tax cost of debt is given as 10% and its cost of common equity is given as 14%. St. Louis Chemical's target capital structure is given as 30% debt and 70% equity. For a detailed discussion of how a firm calculates its cost of debt and cost of equity see Eugene Brigham and Joel Houston's "Fundamentals of Financial Management," Concise 6th edition, Thomson South-Western, a part of the Thomson Corporation, 2009 or a number of other finance textbooks.
2 Calculate St. Louis Chemical's WACC using a 30% debt and 70% equity capital structure.
WACC = [w.sub.d] ([r.sub.d]) (1-t) + [w.sub.s] ([r.sub.s])
Where: [w.sub.d] = weight of debt in the company's target capital structure
[r.sub.d] = before-tax cost of debt
t = marginal income tax rate
[w.sub.s] = weight of equity in the company's target capital structure
[r.sub.s] = cost of equity
WACC = .30 (.10) (1-.35) + .70 (.14)
= .0195 +.0980
= .1175 or 11.75%
3 Recalculate St. Louis Chemical's WACC (round to the nearest whole number) using a 40% debt and 60% equity capital structure.
WACC = .40 (.10) (1-.35) + .60 (.14)
= .0260 +.0840
= .1100 or 11.00%
4 Explain the difference between your answer to questions 2 and 3.
The use of debt lowers the cost of capital because lower cost debt capital is substituted for higher cost equity capital. Using more debt in the firm's capital structure will substitute more low cost debt capital for high cost equity, thus the cost of capital with the 40% debt and 60% equity is less than the 30%/70% structure.
In reality the increased use of debt in a firm's capital structure will cause the cost of debt and the cost of equity to increase. The cost of debt increases because of the increased risk to the lender due to a higher debt ratio and times interest earned (TIE) ratio. The cost of equity increases due to the higher financial leverage.
5 What arguments should be made to convince the Williams of the advantage of using long-term debt in the firm's capital structure? What are the disadvantages?
The best argument that can be made to convince the Board to use debt capital in its capital structure is to calculate the firm's WACC with and without debt. Without debt the firm's cost of capital is 14% (cost of capital and cost of equity are the same) and with 30% debt, St.
Louis Chemical's cost of capital is 11.75%.
The use of debt lowers the cost of capital because lower cost debt capital is substituted for higher cost equity capital. Debt has a lower cost than equity because to the holder of debt there is less risk. Debt has less risk because the certainty of payments associated with debt (interest and principal) is greater than the payments associated with equity (dividends and stock appreciation). Interest and principal payments are legal obligations associated with debt thus are paid before any payment to equity shareholders. Because there is less risk associated with debt, the providers of debt are satisfied with a lower but more certain return. The downside of debt is the fixed nature of the payments, thus the use of debt by a firm increases its financial risk. The greater the percentage of debt used in a firm's capital structure, the greater the financial risk or financial leverage. The introduction of debt into a firm's capital structure will at first cause the WACC to decline, but eventually the use of large amounts of debt will cause the WACC to increase. What businesses attempt to achieve is a capital structure which provides the lowest cost of capital because it is at that point the value of the firm is maximized.
6 Explain why an accurate WACC is important to a firm's long-term success.
A firm's WACC is used to assess investment decisions. Assets must return at least the firm's cost of capital (what it must pay for the capital to acquire the asset). If an asset's return is less than the WACC, shareholders will not receive their required return. If a firm under estimates its WACC then it may invest in assets (projects) that do not yield the necessary return. If a firm over estimates its WACC then it may not invest in assets that would yield the necessary return (missed opportunities). Either error will result in problems. If the WACC is under estimated, the firm risks losing equity capital when dissatisfied investors take their funds elsewhere or will have difficulty raising capital in the future. If the WACC is over estimated, the firm risks missing profitable growth opportunities.
David A. Kunz, Southeast Missouri State University
Benjamin L. Dow III, Southeast Missouri State University
Schedule One St. Louis Chemical Income Statements (000's/$) 2007 2008 $ % $ % Revenue 14,378 100 16,470 100 Cost of Goods Sold 12,145 84.47 13,916 84.49 Gross Profit 2,233 15.53 2,554 15.51 Operating Expenses Selling 756 5.26 842 5.11 General & Administrative 588 4.09 701 4.26 Total Operating Expenses 1,344 9.35 1,543 9.37 Operating Profit 889 6.18 1,011 6.14 Interest Expense 6 0.04 4 0.02 Earnings Before Taxes 883 6.14 1,007 6.12 Income Tax Expense 309 2.15 352 2.14 Earnings After Taxes 574 3.99 655 3.98 2009 $ % Revenue 17,970 100 Cost of Goods Sold 15,172 84.43 Gross Profit 2,798 15.57 Operating Expenses Selling 885 4.92 General & Administrative 791 4.4 Total Operating Expenses 1,676 9.32 Operating Profit 1,122 6.25 Interest Expense 2 0.01 Earnings Before Taxes 1,120 6.24 Income Tax Expense 392 2.18 Earnings After Taxes 728 4.06 Schedule Two St. Louis Chemical Balance Sheets (000's/$) 2007 2008 $ % $ % Current Assets Cash 25 0.42 22 0.34 Receivables 1,432 24.07 1,654 25.24 Inventory 1,682 28.27 1,898 28.97 Other current assets 32 0.54 37 0.56 Total current assets 3,171 53.29 3,611 55.11 Fixed Assets Land 443 7.45 443 6.76 Gross plant,property & equip 3,318 55.77 3,627 55.36 (less accumulated depreciation) (982) (16.50) (1,129) (17.23) Net plant, property & equip 2,336 39.27 2,498 38.13 Total fixed assets 2,779 46.71 2,941 44.89 Total Assets 5,950 100.00 6,552 100.00 Current liabilities Account payables 839 14.10 947 14.45 Short-term notes payables - 0.00 - 0.00 Accrued liabilities 421 7.08 480 7.33 Total current liabilities 1,260 21.18 1,427 21.78 Long-term liabilities 60 1.01 40 0.61 Total liabilities 1,320 22.19 1,467 22.39 Shareholders' equity Common stock 2,000 33.61 2,000 30.53 Retained earnings 2,630 44.20 3,085 47.08 Total equity 4,630 77.81 5,085 77.61 Total liabilities & equity 5,950 100.00 6,552 100.00 2009 $ % Current Assets Cash 23 0.32 Receivables 1,876 26.36 Inventory 2,013 28.28 Other current assets 46 0.65 Total current assets 3,958 55.61 Fixed Assets Land 443 6.22 Gross plant,property & equip 3,989 56.05 (less accumulated depreciation) (1,273) (17.89) Net plant, property & equip 2,716 38.16 Total fixed assets 3,159 44.39 Total Assets 7,117 100.00 Current liabilities Account payables 1,043 14.66 Short-term notes payables - 0.00 Accrued liabilities 441 6.20 Total current liabilities 1,484 20.86 Long-term liabilities 20 0.28 Total liabilities 1,504 21.14 Shareholders' equity Common stock 2,000 28.10 Retained earnings 3,613 50.76 Total equity 5,613 78.86 Total liabilities & equity 7,117 100.00
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|Title Annotation:||Instructor's Note|
|Author:||Kunz, David A.; Dow, Benjamin L., III|
|Publication:||Journal of the International Academy for Case Studies|
|Article Type:||Case study|
|Date:||Feb 1, 2011|
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