Calculate Barbow’s After-Tax Weighted Average Cost Of Capita

Calculate Barbow’s after-tax weighted average cost of capital, using the data in the balance sheet above.

Barbow Enterprises Inc. is contemplating an expansion and requires an assessment of its weighted average cost of capital (WACC) to make informed financing decisions. The WACC reflects the company's overall cost of capital, considering the proportional weights of debt and equity, adjusted for tax benefits associated with debt financing. In this analysis, I will utilize the data provided from Barbow's balance sheet and specific financial details to accurately compute its after-tax WACC.

Introduction

The weighted average cost of capital (WACC) is an essential financial metric used by firms to evaluate investment opportunities and determine the minimum acceptable return on new projects. It incorporates the costs of equity and debt, weighted by their respective proportions in the firm's capital structure. Given that debt provides tax advantages due to deductible interest payments, the after-tax cost of debt is used in the WACC calculation (Ross, Westerfield, & Jaffe, 2021). This paper elucidates the process of calculating Barbow Enterprises' WACC by examining the inputs derived from the company's balance sheet and financial metrics.

Data Overview

The data provided include:

  • Cost of Common Equity: 15%
  • Before-tax Cost of Debt: 12%
  • Tax Rate: 40%
  • Balance Sheet Assets and Liabilities:
  • Cash: $240
  • Accounts Receivable: $480
  • Inventories: $720
  • Net Property & Equipment (P&E): $4,320
  • Total Assets: $5,760
  • Long-term Debt: $2,304
  • Owners' Equity: $3,456

The balance sheet indicates a capital structure composed of debt and equity, with debt totaling $2,304 and equity totaling $3,456. Since the stock sells at book value, the market values of debt and equity are assumed to equal their book values, facilitating the calculation of weights in the WACC formula (Brealey, Myers, & Allen, 2019).

Calculating the Weights of Debt and Equity

The first step involves determining the proportion of debt and equity in the total capital structure:

Weight of Debt (WD):

W_D = Long-term Debt / Total Capital = $2,304 / $5,760 ≈ 0.40

Weight of Equity (WE):

W_E = Equity / Total Capital = $3,456 / $5,760 ≈ 0.60

These weights reflect the firm's financial leverage and are used to compute the cost contributions of each component to WACC.

Calculating the After-tax Cost of Debt

The pre-tax cost of debt is given as 12%, and considering the tax shield, the after-tax cost of debt (rD) is calculated as:

r_D (after-tax) = r_D (pre-tax) × (1 - Tax Rate) = 12% × (1 - 0.40) = 12% × 0.60 = 7.2%

This reduction reflects the tax deductibility of interest expenses, which lowers the firm's overall cost of debt (Brigham & Ehrhardt, 2016).

Incorporating the Cost of Equity

The cost of equity is provided as 15%. Given that equity investors require this return due to the risk associated with ownership, it directly enters into the WACC calculation without modification.

Calculating the WACC

The formula for WACC is as follows:

WACC = (WE × rE) + (WD × rD)

Substituting the values:

WACC = (0.60 × 15%) + (0.40 × 7.2%) = 0.60 × 0.15 + 0.40 × 0.072 = 0.09 + 0.0288 = 0.1188

Expressed as a percentage, the weighted average cost of capital is approximately:

WACC ≈ 11.88%

This WACC indicates the minimum return Barbow needs to generate on its expansion projects to satisfy its investors and debt holders, adjusted for the tax benefits of its debt structure.

Conclusion

In conclusion, Barbow Enterprises Inc. has an after-tax weighted average cost of capital of approximately 11.88%. This figure provides a critical benchmark for evaluating potential investment opportunities and ensuring that new projects are financially viable and aligned with the company's cost of capital. Proper understanding and calculation of WACC support effective financial planning and strategic decision-making, contributing to long-term value creation for stakeholders.

References

  • Brealey, R. A., Myers, S. C., & Allen, F. (2019). Principles of Corporate Finance (13th ed.). McGraw-Hill Education.
  • Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice (15th ed.). Cengage Learning.
  • Ross, S. A., Westerfield, R. W., & Jaffe, J. (2021). Corporate Finance (12th ed.). McGraw-Hill Education.
  • Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. Wiley Finance.
  • Higgins, R. C. (2018). Analysis for Financial Management (11th ed.). McGraw-Hill Education.
  • Modigliani, F., & Miller, M. H. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. American Economic Review, 48(3), 261–297.
  • Investopedia. (2023). Weighted Average Cost of Capital (WACC). https://www.investopedia.com/terms/w/wacc.asp
  • Financial Times. (2023). Cost of Capital Data and Market Yields. https://www.ft.com/markets/interest-rates
  • Morningstar. (2023). Bond Yields and Market Data. https://www.morningstar.com/bonds
  • U.S. Treasury Department. (2023). Treasury Yields Data. https://home.treasury.gov/policy-issues/financing-the-government/interest-rate-statistics

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