The balance sheet that follows indicates the capital structure for Nealon Inc. F
ID: 2665813 • Letter: T
Question
The balance sheet that follows indicates the capital structure for Nealon Inc. Flotation costs are (a) 15 percent of market value for a new bond issue, and (b) $2.01 per share for preferred stock. The dividends for common stock were $2.50 last year and are projected to have an annual growth rate of 6 percent. The firm is in a 34 percent tax bracket. What is the weighted average cost of capital if the firm's finances are in the following proportions?Type of financing Percentage of future financing
Bonds (8%, 1,000 par, 16-year maturity) 38%
Preferred stock (5,000 shares oustanding,
$50 par, $1.50 dividend) 15%
Common equity 47%
Total 100%
a. Market prices are $1,035 for bonds, $19 for preferred stock, and $35 for common stock. There will be sufficient internal common equity funding (i.e., retained earnings) available such that the firm does not plan to issue new common stock. Calculate the firm's weihted average costs of capital.
b. In part a we assumed that Nelson would have suffiicient retained earnings such that it would not need to sell additional common stock to finance its new investments. Consider the situation now, when Nealon's retained earnings anticipated for the coming year are expected to fall short of the equity requirement of 47 percent of new common shares will have to be raised. Consequently, the firm foresees the possibility that new common shares will have to be issued. To facilitate the sale of shares, Nealon's investment banker has advised management that they should expect a price discount of approximately 7 percent, or $2.45 per share. Under these terms, the new shares should provide net proceeds of about $32.55. What is Nealon's cost of equity capital when new shares are sold, and what is the weighted average cost of added funds involved in the issurance of new shares?
Explanation / Answer
a) Calculating the Weighted average cost of capital : The formula for calculating WACC is WACC = Wd * Rd * (1-Tc) + We * Re + Wp * Rp Where Wd is the weight of debt = 38% We is the weight of equity = 47% Wp is the weight of preferred stock = 15% Rd is the cost of debt Re is the cost of equity Rp is the cost of preferred stock Tc is the tax rate = 34% Calculating the cost of debt using excel sheet: Coupon payment = Coupon rate * Face value of the bond = 8% * $1000 = $80 Present value of the bonds after flotation costs = $1035 - 15% ($1035) = $1035 - $155.25 = $879.75 or $880 Step1: Go to excel and click "insert" to insert the function Step2: Select the "Rate" function as we are finding the cost of debt in this case. Step3: Enter the values as Nper = 16; PMT = -80; PV = 880; FV = -1000 Step4: Click "OK" to get the desired value. The value comes to "9.49%" Therefore, the cost of debt is 9.49% Calculating the cost of preferred stock: Rp = D / (P0 - flotation cost per share) = $1.50 / ($19 - $2.01) = $1.50 / $16.99 = 0.088 or 8.8% CAlculating the cost of equity using Dividend discount model: Re = (D1 / P0) + g D1 = D0 (1+g) = $2.50 (1 + 0.06) = $2.65 Re = ($2.65 / $35) + 0.06 = 0.1357 or 13.57% Substituting the values in the WACC formula, we get WACC = 0.38 * 0.095 * (1 - 0.34) + 0.15 * 0.088 + 0.47 * 0.1357 = 0.0238 + 0.0132 + 0.0638 = 0.1008 or 10.08% Therefore, the weighted average cost of capital is 10.08% b) New price for common stock is $32.55 Calculating the new cost of equity: Re = (D1 / P0) + g = ($2.65 / $32.55) + 0.06 = 0.0814 + 0.06 = 0.1414 or 14.14% Computing the WACC: WACC = 0.38 * 0.095 * (1 - 0.34) + 0.15 * 0.088 + 0.47 * 0.1414 = 0.0238 + 0.0132 + 0.066 = 0.103 or 10.3% Therefore, the new WACC is 10.3% = 0.0238 + 0.0132 + 0.066 = 0.103 or 10.3% Therefore, the new WACC is 10.3%Related Questions
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