The Nealon Manufacturing Company is in the midst of negotiations to acquire a pl

Question

The Nealon Manufacturing Company is in the midst of negotiations to acquire a plant in Fargo, North
Dakota. The company CFO, James Nealon, is the son of the founder and CEO of the company and
heir -apparent to the CEO position, so he is very concerned about making such a large commitment of
money to the new plant. The cost of the purchase is $40 million, which is roughly one -half the size of
the company today.
To begin his analysis, James has launched the firm’s first ever cost -of – capital estimation. The
company’s current balance sheet, restated to reflect market values, has been converted to percentages
as follows:
Nealon, Inc., Balance Sheet—2013
Type of Financing
Percentage of Future Financing
Bonds (8%, $1,000 par, 30 – year maturity)   38%
Preferred stock (5,000 shares outstanding, $50 par, $1.50 dividend) 15%
Common stock   47%
Total   100%

The company paid dividends to its common stockholders of $2.50 per share last year, and the
projected rate of annual growth in dividends is 6 percent per year for the indefinite future. Nealon’s
common stock trades over the counter and has a current market price of $35 per share. In addition, the
firm’s bonds have an AA rating. Moreover, AA bonds are currently yield ing 7 percent. The preferred
stock has a current market price of $19 per share.

a. If the firm is in a 34 percent tax bracket, what is the weighted average cost of capital (i.e., firm
WACC)?
b. In the analysis done so far we have not considered the effects of flotation costs. Assume now that
Nealon is raising a total of $40 million using the above financing mix. New debt financing will require
that the firm pay 50 basis points (i.e., o ne -half a percent) in issue costs, the sale of preferred stock
will
require the firm t o pay 200 basis points in flotation costs, and the common stock issue will require
flotation costs of 500 basis points.
i. What are the total flotation costs the fir m will incur to raise the needed $40 million?
ii. How should the flotation costs be incorporated into the analysis of the $40 million investment the
firm plans to make?

Please explain in excel if you can. I would like to see how it is broke the answer is broken down so I can use that on the rest of my homework :) Thank you in advance!

Explanation / Answer

Part A)

The formula for calculating weighted average cost of capital has been given below:

Weighted Average Cost of Capital (WACC) = After-Tax Cost of Debt*Weight of Debt + Cost of Preferred Stock*Weight of Preferred Stock + Cost of Equity*Weight of Equity

______________________

The after-tax cost of debt can be calculated with the use of following formula:

After-Tax Cost of Debt = Cost of Debt*(1-Tax Rate) where Cost of Debt = Yield on Bonds

___________

Using the information provided in the question, we get,

After-Tax Cost of Debt = 7%*(1-34%) = 4.62%

_________________

The cost of preferred stock can be calculated with the use of following formula:

Cost of Preferred Stock = Annual Dividend/Current Market Price*100

___________

Using the information provided in the question, we get,

Cost of Preferred Stock = 1.50/19*100 = 7.89%

_________________

The cost of common stock can be calculated with the use of following formula:

Cost of Common Stock = D1/Current Stock Price + Growth Rate where D1 = D0*(1+Growth Rate)

___________

Using the information provided in the question, we get,

Cost of Equity = 2.50*(1+6%)/35 + 6% = 13.57%

_________________

Using the values calculated above in the formula for WACC, we get,

WACC = 4.62%*38% + 7.89%*15% + 13.57%*47% = 9.32%

___________________________

Part 2)

Flotation costs will be deducted from the price of each issue made by the company. To determine the flotation cost, we will have to divide the total amount to be raised between debt, preferred stock and equity (in the proportion of their weights respectively).

Part i and Part ii, both have been answered in the following table:

___________

Now, we will have to calculate the revised cost of different instruments with the use of revised prices.

The revised price of bond can be calculated with the use of PV function/formula of EXCEL/Financial Calculator. The formula/function for PV is PV(Rate,Nper,PMT,FV) where Rate = Yield, Nper = Period, PMT = Interest Payment and FV = Face Value

__________

Here, Rate = 7%, Nper = 30, PMT = $1,000*8% = $80 and FV = $1,000

Using these values in the above function/formula for PV, we get,

Bond Price = PV(7%,30,80,1000) = $1,124.90

Bond Price After Adjustment for Flotation Cost = 1,124.90*(1-.5%) $1,118.47

_______

Now, we will have to use the revised bond price to calculate the revised cost of debt. The cost of debt can be calculated with the use of Rate function/formula of EXCEL/Financial Calculator. The formula/function for Rate is Rate(Nper,PMT,-PV,FV) where Nper = Period, PMT = Interest Payment, PV = Price of Bonds, FV = Face Value of Bonds

_______

Using the revised price calculated above, we get,

Revised Cost of Debt = Rate(30,80,-1118.47,1000) = 7.04%

Revised After-Tax Cost of Debt = 7.04%*(1-34%) = 4.65%

___________

Revised Cost of Preferred Stock = 1.50/(19 - 2*19%)*100 = 8.06%

___________

Revised Cost of Equity = 2.50*(1+6%)/(35 - 35*5%) + 6% = 13.97%

___________

Revised WACC = 4.65%*38% + 8.06%*15% + 13.97%*47% = 9.54%

Capital Weight Value of Capital (Amount to be Raised*Weight) (A) Flotation Cost (B) Total Flotation Cost (A*B) Debt 38% $1,52,00,000.00 0.50% $76,000.00 Preferred Stock 15% $60,00,000.00 2% $1,20,000.00 Equity 47% $1,88,00,000.00 5% $9,40,000.00 Total Flotation Cost $11,36,000.00

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