Submit A Written Paper Which Is 2-3 Pages In Length Excludin

Submit A Written Paper Which Is At 2 3 Pages In Length Exclusive Of T

Discuss the case study of Comic Book Publication Group (CBPG), including its current capital structure, and analyze the impact of issuing an additional $10 million in bonds at a 4% coupon rate, on the company's weighted average cost of capital (WACC). The paper should explain the approach used to calculate the current and new WACC, incorporate the tax shield benefits of debt, and provide a clear, logical conclusion about the implications of the new debt issuance on the company’s overall cost of capital.

Paper For Above instruction

The case of Comic Book Publication Group (CBPG) presents a practical scenario for understanding how changes in a firm’s capital structure influence its weighted average cost of capital (WACC). This paper aims to analyze CBPG’s current capital structure, calculate its existing WACC, project the new WACC following the proposed debt issuance, and discuss the implications of these financial decisions, especially focusing on the tax shield benefits associated with increased leverage.

Understanding WACC and Its Importance

The weighted average cost of capital (WACC) represents the average rate that a company is expected to pay to finance its assets through both debt and equity. It is a critical measure used in discounted cash flow (DCF) valuation models, as it reflects the opportunity cost of capital and serves as a benchmark for investment decisions. A lower WACC indicates a cheaper cost of financing, potentially leading to higher valuation, while a higher WACC can signal increased risk and higher financing costs (Damodaran, 2012).

Current Capital Structure and Calculation of WACC

CBPG’s existing capital structure includes $12 million in bonds, $5 million in preferred stock, and $6 million in common equity. To calculate the current WACC, we start by determining the proportion and costs of each component:

  • Debt: $12 million at a 5% coupon rate
  • Preferred stock: $5 million with a dividend of $1.75 per share and a par value of $35
  • Common equity: $6 million with a cost of capital of 10%

The after-tax cost of debt is calculated considering the corporate tax rate of 33%, which provides a tax shield, reducing effective borrowing costs:

  • After-tax cost of debt = 5% × (1 - 0.33) = 3.35%

The cost of preferred stock is calculated as:

Preferred dividend rate = $1.75 / $35 = 5%

Similarly, with the cost of equity at 10%, the weights are determined based on market values. For simplicity, assume book values approximate market values in this scenario.

Current WACC can then be calculated as:

WACC = (E/V) × Re + (D/V) × Rd × (1 - Tc) + (P/V) × Rp

Where:

  • E = market value of equity = $6 million
  • D = market value of debt = $12 million
  • P = market value of preferred stock = $5 million
  • V = total value = E + D + P = $23 million
  • Re = cost of equity = 10%
  • Rd = cost of debt before tax = 5% (used for calculation, adjusted for tax)
  • Rp = cost of preferred stock = 5%

Hence, the current WACC is roughly:

WACC ≈ (6/23) × 10% + (12/23) × 3.35% + (5/23) × 5% ≈ 2.61% + 1.75% + 1.09% ≈ 5.45%

Proposed Debt Issuance and New WACC

The company plans to issue an additional $10 million in bonds at par with a 4% coupon rate. The new debt component becomes $12 million + $10 million = $22 million. The total firm value adjusts to:

V_new = E + D_new + P = $6 million + $22 million + $5 million = $33 million (assuming the equity remains unchanged)

The new weight of debt is:

D/V = 22 / 33 ≈ 66.67%

The after-tax cost of new debt is:

  • Rd_new = 4% × (1 - 0.33) = 2.68%

The cost of equity remains at 10%, and the preferred stock remains unchanged. The new WACC is calculated as:

WACC_new = (E/V_new) × Re + (D/V_new) × Rd_new × (1 - Tc) + (P/V_new) × Rp

Assuming the equity value remains $6 million, the weight of equity is:

E/V_new = 6 / 33 ≈ 18.18%

Thus, the new WACC becomes:

WACC_new ≈ 0.1818 × 10% + 0.6667 × 2.68% + 0.1515 × 5% ≈ 1.82% + 1.79% + 0.76% ≈ 4.37%

Implications of the Debt Increase and Tax Shields

The issuance of additional debt reduces the overall WACC from approximately 5.45% to 4.37%, illustrating the benefit of debt financing due to the tax shield. Debt financing’s tax shield—equal to the interest paid multiplied by the tax rate—reduces the effective cost of debt and enhances firm value (Modigliani & Miller, 1963). This leverage effect is critically important for optimizing capital structure, balancing the benefits of debt with its associated risks, such as financial distress and increased bankruptcy risk (Frank & Goyal, 2009).

Specifically, the tax shield increases the present value of tax savings, contributing positively to the company’s valuation. The optimal capital structure balances the tax advantages with the potential costs associated with excessive leverage, as higher debt levels may lead to increased bankruptcy risk and agency costs.

Conclusion

The analysis indicates that issuing additional debt at a lower coupon rate can significantly reduce CBPG’s WACC, thereby decreasing the company's overall cost of capital and potentially increasing its valuation. The tax shield benefits associated with debt amplify this advantage. However, it is important for management to consider the risks of higher leverage, including financial distress costs and impact on credit ratings. Overall, strategically increasing leverage through carefully structured debt issuance appears beneficial for CBPG’s financial health and growth prospects, provided the firm maintains an optimal capital balance that mitigates risks while maximizing tax benefits.

References

  • Damodaran, A. (2012). Investment valuation: Tools and techniques for determining the value of any asset. John Wiley & Sons.
  • Frank, M. Z., & Goyal, V. K. (2009). Capital structure decisions: which factors are reliably important? Financial Management, 38(1), 1-37.
  • Modigliani, F., & Miller, M. H. (1963). Corporation income taxes and the cost of capital: a correction. American Economic Review, 53(3), 443-453.
  • Ross, S. A., Westerfield, R., & Jaffe, J. (2013). Corporate Finance (10th ed.). McGraw-Hill Education.
  • Brigham, E. F., & Ehrhardt, M. C. (2013). Financial Management: Theory & Practice. Cengage Learning.
  • Myers, S. C. (2001). The capital structure puzzle. Journal of Finance, 39(3), 575-592.
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  • Titman, S., & Wessels, R. (1988). The determinants of capital structure choice. Journal of Finance, 43(1), 1-19.
  • Graham, J. R. (2000). How big are the tax benefits of debt? Journal of Finance, 55(5), 1901-1941.
  • Kaplan, S. N., & Strömberg, P. (2003). financiers of growth. Journal of Finance, 58(2), 591-634.

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