The Castillo Products Company was started in 2008. The company manufactures components for personal digital assistant (PDA) products and for other handheld electronic products. A difficult operating year, 2009, was followed by a profitable 2010. 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 …show more content…

The combined result was a change in the return on equity of -15.22% in 2009 to a positive 15.96% for 2010.

(b) Cost of short-term bank loans:
Current interest rate is given at 8.00% Cost of default-risk free long-term government bonds: current interest rate is given at 7.00% [The sum of the expected real rate of 2.00% and expected inflation rate of 3.00% is 5.00%. Since this is less than the current 7% long-term government bond rate, current government bond investors are expecting different real interest rates and/or inflation rates amounting to a total of 2.00%.]

Cost of risky long-term debt: Cost of risky debt = long-term government bond rate + default-risk premium + liquidity premium = 7.00% + 6.00% +3.00% = 16.00%

Large-firm common equity capital: Large firm cost of common equity (CAPM method) = default-risk free rate on long-term government bonds + (large firm market risk premium) x (market beta) = 7.00% + (6.00%)(1.00) = 13.00%

Castillo Products common equity capital: Capital asset pricing model (CAPM) = 7.00% + (6.00%)(2.00) = 7.00% + 12.00% = 19.00%

(c) After-tax cost of short-term bank loans:
8.00% x (1 – .30) = 8.00% x .70 = 5.60%

After-tax cost of risky long-term debt:
16.00% x (1 - .30) = 16% x .70 = 11.20%

After-tax cost of Castillo Products’ common equity:
19.00%

(d) Percent After-tax Component Book