Cost of Capital and Weighting System. Electro Tool Co., a manufacturer of diamond drilling, cutting, and grinding tools, has $1 million of its 8 percent debenture issue maturing on September 1, 20X1. The $1 million that has been accumulated to retire this debt is now going to be used to acquire additional manufacturing machinery. To meet the debt and purchase of machinery, an additional $1 million must be raised. One proposal that has been particularly appealing is the sale and lease-back of the company’s general office building. This proposal has a lower interest cost than the financing program proposed by the equipment vendor.
The building would be sold to FHR, Inc., for $1 million and leased back on a 25-year lease. The lease calls for Electro Tool to pay $110,168 annually, which permits FHR, Inc., to recover its investment and earn 10 percent on the investment. Electro Tool will pay for all maintenance costs, property taxes, and insurance during the lease period. At the end of the 25 years Electro Tool will reacquire the building for a very small payment. The sale and lease-back will be treated the same for both financial reporting and income tax purposes.
The current capital structure and cost of the individual components for Electro Tool Co. are shown below.
Capital Component Amount per Recent Balance Sheet Before-Tax Component Cost (%)
8% debentures (including $ 5,000,000 8
the $1,000,000 to be retired)
9% preferred stock 1,000,000 9
Common stock 2,000,000 13
Retained earnings 2,000,000 12
$10,000,000
Electro Tool is subjected to a 40 percent income tax rate.
(a) Using the data provided, calculate the historical weighted average cost of capital of Electro Tool Co. (1) before the retirement of the debentures and the sale and lease-back action, and (2) after the retirement of the debentures and the sale and lease-back transaction. (b) If the component costs and weightings used to calculate the weighted average cost of capital in (a) (1) are different from those used in (a) (2), explain why. If the amounts used to calculate (a) (1) are the same as those used in (a) (2), explain why. (c) Market values for the capital components were not presented. What arguments are given to support the use of market values in calculating the weighted average cost of capital? (CMA, adapted.)