Business growth has been steady but a recent increase in demand has placed a strain on existing operations. To keep pace with demand, the capacity of the current warehouse and packaging operations needs to be increased. The cost of the facility expansion has been estimated to be $900,000 by St. Louis Chemical’s operation manager. In addition to avoiding risky capital expenditures, Williams has also followed a conservative financing policy. Since beginning operations, he has been reluctant to borrow funds, content with limited growth, financed with internally generated equity. The only long-term debt on the company’s balance sheet reflects vehicle financing. If the facility is to be expanded, additional external financing will be necessary and the current shareholders are reluctant to invest additional funds. St. Louis Chemical’s income statement and balance sheet for the years 2007-2009 are provided in Schedules One and Two, respectively. Hesselbach, using input from an investment-banking firm, has estimated the company's cost of equity to be 14%. A St. Louis bank has indicated a long-term bank loan can be arranged to finance expansion at an annual interest rate of 10%. The bank would require either loan to be secured with expansion and other company assets. The loan agreement would also include a number of restrictive covenants, including a limitation of dividends while the loans are outstanding. Only a small amount of long-term debt is included in the firm's current capital structure, the firm’s debt ratio at the end of 2009 was 21% and long-term debt was only .28% of total assets. Hesselbach calculated that if a long-term bank loan was used to obtain the needed $900,000, the firm’s debt ratio would increase to 30%. He believes a 30% debt and 70% equity capital mix would be conservative and a starting point for introducing long-term debt into the firm’s capital structure. Last year the company's federal-plus-state income tax rate was 35%. Hesselbach does not expect the income tax rate to change in the foreseeable future. Hesselbach has recommended borrowing the required funds. Williams indicated he may be willing to consider a change in his long-standing policy against debt, but wants more information regarding the advantages and disadvantages of using debt in the firm's capital structure.

1. Prepare a presentation for Williams regarding the concept of a firm’s weighted average cost of capital (WACC).

2. Calculate St. Louis Chemical’s WACC using a 30% debt and 70% equity capital structure.

3. Recalculate St. Louis Chemical’s WACC (round to the nearest whole number) using a 40% debt and 60% equity capital structure.

4. Explain the difference between your answer to questions 2 and 3.

5. What arguments should be made to convince the Williams of the advantage of using long-term debt in the firm's capital structure? What are the disadvantages?

6. Explain why an accurate WACC is important to a firm's long-term success.

Answer rating: 100% (QA)

1 Presentation for Williams regarding the concept of a firms weighted average cost of capital WACC Weighted Average Cost of Capital WACC is a measure of the overall cost of capital for a company It is ... View the full answer