The Castillo Products Company was started in 2014. The company manufactures components for personal digital assistant (PDA) products and for other handheld electronic products. A difficult operating year, 2015, was followed by a profitable 2016. The founders (Cindy and Rob Castillo) are interested in estimating their cost of financial capital because they are expecting to secure additional external financing to support planned growth. Short-term bank loans are available at an 8 percent interest rate. Cindy and Rob believe that the cost of obtaining long term debt and equity capital will be somewhat higher. The real interest rate is estimated to be 2 percent, and a long-run inflation premium is estimated at 3 percent. The interest rate on long-term government bonds is 7 percent. A default-risk premium on long-term debt is estimated at 6 percent; plus Castillo Products is expecting to have to pay a liquidity premium of 3 percent due to the illiquidity associated with its long-term debt. The market risk premium on large-firm common stocks over the rate on long-term government bonds is estimated to be 6 percent. Cindy and Rob expect that equity investors in their venture will require an additional investment risk premium estimated at two times the market risk premium on large-firm common stocks. Following are income statements and balance sheets for the Castillo Products Company for 2015 and 2016.

        

A. Calculate the net profit margin, total-sales-to-total-assets ratio, the equity multiplier, and the return on equity for both 2015 and 2016 for the Castillo Products Corporation. Describe what happened in terms of financial performance between the two years.
B. Estimate the cost of short-term bank loans, long-term debt, and common equity capital for the Castillo Products Corporation.
C. Although, Castillo Products paid a low effective tax rate in 2016, a 30 percent income tax rate is considered more appropriate when looking to the future. Estimate the after-tax cost of short-term bank loans, long-term debt, and the venture€™s common equity.
D. Estimate the weighted average cost of capital (WACC) for the Castillo Products Corporation using the book values of interest-bearing debt and stockholders€™ equity capital at the end of 2016.
E. Cindy and Rob estimate that the market value of the common equity in the venture is $900,000 at the end of 2016. The market values of interest-bearing debt are judged to be the same as the recorded book values at the end of 2016. Estimate the market value-based weighted average cost of capital for Castillo Products.
F. Would you recommend to Cindy and Rob that they use the book value€“based WACC estimate or the market value€“ based WACC estimate for planning purposes? Why?

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CASTILLO PRODUCTS COMPANY INCOME STATEMENT 2015 2016 $ 900,000 $1,500,000 Net sales Cost of goods sold 540,000 900,000 Gross profit 360,000 600,000 Marketing General and administrative 90,000 150,000 250,000 250,000 Depreciation 40,000 40,000 -20,000 EBIT 160,000 Interest 45,000 60,000 Earnings before taxes -65,000 100,000 Income taxes 25,000 $ -65,000 $ 75,000 Net income (loss) BALANCE SHEET 2015 2016 $ 50,000 $ 20,000 Cash 200,000 Accounts receivable 280,000 Inventories 400,000 500,000 Total current assets 650,000 800,000 450,000 Gross fixed assets 540,000 Accumulated depreciation -100,000 350,000 $1,000,000 $ 130,000 -140,000 Net fixed assets 400,000 Total assets $1,200,000 $ 160,000 Accounts payable Accruals 50,000 70,000 Bank loan 90,000 100,000 Total current liabilities 270,000 330,000 Long-tem debt 300,000 400,000 Common stock ($0.05 par value) 150,000 150,000 Additional paid-in-capital 200,000 200,000 Retained earnings Total liabilities and equity 80,000 $1,000,000 120,000 $1,200,000