THREE-STEP PROCESS FOR ESTIMATING A FIRM’S WACC
THREE-STEP PROCESS FOR ESTIMATING A FIRM’S WACC, 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, 2006Liabilities and owner’s capital Balance sheet Invested Capital(Book value) (Market values)Current LiabilitiesAccounts Payable 8,250,000Notes payable 0 0Other current liabilities 7,266,000Total current liabilities 15,516,000 Long term debt (8.5% interest paidSemiannually, due in 2015) 420,000,000 434,091,171Total liabilities 435,516,000 434,091,171Owners’ capitalCommon stock ($1 par value per share) 40,000,000Paid in capital 100,025,000Accumulated earnings 255,000,000 Total owners’ capital 395,025,000Total liabilities and owners’ capital 830,541,000 1,334,091,171Compano’s 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 firm’s CFO has initiated a cost of capital study by one of his senior financial analysts, Jim Tipolli. Jim’s first action was to contact the firm’s investment banker to get input on current capital costs.Jim learned that although the firm’s 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 compano’s 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 Compano’s total invested capital and capital structure weights for debt and equity?B. Based on Compano’s corporate income tax rate of 40%, the firm’s current capital structure, and an unlevered beta estimate of .90. What is Compano’s 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 Jim’s estimate of Compano’s cost of equity be if he uses the CAPM?D. What is your estimate of Companos’s WACC?
