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St. Louis Chemical: cost of capital.(Instructor's Note)

CASE DESCRIPTION

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.

CASE SYNOPSIS

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.

CASE USE

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.

CASE OVERVIEW

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.

DISCUSSION QUESTIONS

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 formula:

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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Article Details
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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
Geographic Code:1USA
Date:Feb 1, 2011
Words:2236
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