The balance sheet that follows indicates the capital structure for Nealon Inc. F
ID: 2671103 • Letter: T
Question
The balance sheet that follows indicates the capital structure for Nealon Inc. Flotation cost 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% tax bracket. What is the weighted average cost of capital if the firm's finances are in the following proportions?Types of Financing: Percent of Future Financing
Bonds (8%, $1,000 par, 16 maturity) 38% Preferred stock (5,000 shares outstanding, $50 par, $1.50 dividend 15% Common Equity 47%
a. Market prices are $1035 for bonds, $19 for preferred stock, and $35 for common stock. There will be sufficient internal common equity funding available such that the firm does not plan to issue new common stock. Calculate the firm's weighted average cost of capital.
b. In part a we assumed that Nealon would have sufficient 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% of new capital raised. To facilitate the sale of shares, Nealon's investment banker has advised management that they should expect a price discount of 7%, 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 the added funds involved in the issuance of new shares?
Explanation / Answer
$1,035 (1 - .15) = $879.75 = NP0
$879.75 = limit t=1 to 16 80/(1+Kd)^t + 1000/ (1+Kd)^16
kd = 9.49%
after tax = 9.51%(1 - .34) = 6.26%
Cost of Preferred Stock:= D/NPo = 8.83%
Cost of Internal Common Funds:= D/Po + g= .1357 = 13.57%
Weighted Cost of Capital (Kwacc) using internal common funds only.
Weights Costs Weighted Costs
Bonds
0.38
6.26%
0.0238
Preferred Stock
0.15
8.83%
0.0132
New Common Stock
0.47
13.57%
0.0638
1.00
.1008 or 10.08%
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b. In part a we assumed that Nealon would have sufficient 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% of new capital raised. To facilitate the sale of shares, Nealon's investment banker has advised management that they should expect a price discount of 7%, 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 the added funds involved in the issuance of new shares?
Raising external common equity
Cost of External Common Stock:
kncs = 14.14%
Weights Costs Weighted Costs
Bonds
0.38
6.26%
0.0238
Preferred Stock
0.15
8.83%
0.0132
New Common Stock
0.47
14.14%
0.0665
1.00
.1035 or 10.35%
Bonds
0.38
6.26%
0.0238
Preferred Stock
0.15
8.83%
0.0132
New Common Stock
0.47
13.57%
0.0638
1.00
.1008 or 10.08%
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