Cost of Capital - West Coast Semiconductor Case Study

Cost of Capital – Case 4A

West Coast Semiconductor Case Study

1. a. Critique WCS' current method of estimating its before-tax cost of debt.

Currently WCS determines its before-tax cost of debt by using the coupon rate on the most recent long term bond. This historical rate is not a good estimate for the before-tax cost of debt. The WACC is used primarily to make investment decisions, so the cost of new capital will be used to finance those projects. The better estimate to use is the marginal cost of new debt. This can be found by finding the yield to maturity (or yield to call). This yield is the rate of return the current bondholders expect to receive, and a good estimate of rd, the rate of return that new bondholders will require.

While considering the tax effects in making financial decisions, either we can incorporate tax effects in capital budgeting cash flows or in cost of capital.

WCS makes a mistake in its current method of estimating its before-tax cost of debt because most firms incorporate tax effects in the cost of capital. Therefore, the estimate should be based on after-tax costs, not before-tax cost of debt.

b. Is earnings yield (E/P) an appropriate measure of the firm's cost of equity?

Earnings yield (E/P) is not an appropriate measure of the firm's cost of equity because the E/P only reflects the current year's earnings and the current share price; it's only a snapshot in time and therefore, future growth is not reflected in the figure (E/P).

2. a. What is your estimate of WCS' cost of debt?

The estimate of WCS' cost of debt is based on the yield on the company's current debts. Therefore, our estimate of WCS' cost of debt is calculated as follows:

PV = -957.5 FV = 1000 PMT = 47.50 N = 40 (2 periods x 20 years)

Input values into a calculator 5%

Yield to Maturity 5% x 2 = 10%

rdBT = 10% T = 40%

Estimate Cost of Debt

rd AT = rd BT(1 – T)

rd AT = 10%(1 – 0.4)

rd AT = 6%

Our estimate of WCS' cost of debt is 6%.

b. Should flotation costs be included in the component cost of debt calculation? Explain.

Theoretically it should be used. However, the costs are minimal in case of debt as compared to preferred stock and common stock, so generally we ignore this cost.

c. Should the nominal cost of debt or the effective annual rate be used?