BASF will invest $14 million this year to upgrade its ethylene glycol processes. This chemical is used to produce polyester resins to manufacture products varying from construction materials to aircraft, and from luggage to home appliances. Equity capital costs 14.5% per year and will supply 65% of the capital funds. Debt capital costs 10% per year before taxes. The effective tax rate for BASF is 36%.
(a) Determine the amount of annual revenue after taxes that is consumed in covering the interest on the project’s initial cost.
(b) If the corporation does not want to use 65% of its own funds, the financing plan may include 75% debt capital. Determine the amount of annual revenue needed to cover the interest with this plan, and explain the effect it may have on the corporation’s ability to borrow in the future.
(a) Determine the after-tax cost of debt capital, Equation [10.4], and WACC
After-tax cost of debt capital = 10(1 - 0.36) = 6.4%
After-tax WACC = 0.35(6.4%) + 0.65(14.5%) = 11.665%
Interest charged to revenue for the project:
14.0 million(0.11665) = $1,633,100
(b) After-tax WACC = 0.25(14.5%) + 0.75(6.4%)
= 8.425%
Interest charged to revenue for the project:
14.0 million(0.08425) = $1,179,500
As more and more capital is borrowed, the company risks higher loan rates and
owns less and less of itself. Debt capital (loans) becomes more expensive and
harder to acquire.
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