China Baowu Steel Group Corporation Limited which is one of the largest steel companies in China manufactures iron and steel products. It offers carbon steel products, including bars, heavy plates, hot rolled (HR) steel sheets, wire rods, and pipe tubes; cold rolled (CR) steel sheets; and stainless steel products. It offers die steel and bearing steel products; cold-rolled roll ingot for mill rolls and mandril; alloys for aviation and aerospace; automotive (transportation) steel products; and stainless steel for fasteners.
The company’s subsidiary, Hong Kong Baowu Steel, is evaluating two different operating structures which are described below. The firm has annual interest expense of $250, common shares outstanding of 1,000, and a tax rate of 40%.
Table 1. Cost Structure Analysis of Hong Kong Baowu Steel
Operating structure 1: Fixed costs $500 Price per unit $1 Variable cost costs per unit $0.75
Operating structure 2: Fixed costs $1,200 Price per unit $1 Variable cost costs per unit $0.70
Table 2. Additional Information on China Baowu Steel
• Yield of ten-year government bonds in the China is 5%.
• Current market value of equity is $200 million with a beta of 1.2.
• Total debt outstanding in book value is $60 million.
• Cash available on hand is $10 million.
• Cost of debt to issue corporate bonds is 6%.
• The tax rate is assumed to be 30%.
a For each operating structure of Hong Kong Baowu Steel, calculate:
i EBIT and EPS at 10,000, 20,000, and 30,000 units;
ii the degree of operating leverage (DOL) and degree of combined leverage (DCL) using 20,000 units as a base sales level; and
iii the operating breakeven point in units.
b Which operating structure has greater operating leverage and business risk for Hong Kong Baowu Steel?
c Based on the above information, evaluate China Baowu Steel’s Weighted Average Cost of Capital (WACC). Show the necessary calculations.
d Critically discuss when it is proper to apply the WACC for assessing a new project for China Baowu Steel.