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, ND. 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, reststed to reflect market values, has been converted to percentages as follows: 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% 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 a AA rating. Moreover, AA bonds are currently yielding 7%, The preferred stock has a current market price of $19 per share. If the firm is in a 34% tax bracket, what is the weighted average cost of capital(i.e., Firm WACC)? 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., one-half a percent) in issue costs, the sale of preferred stock will require the firm to pay 200 basis points in flotation costs of 500 basis points. What are the total flotation costs the firm will incur to raise the needed $40million? How should the flotation costs be incorporated into the analysis of the $40 million investment the firm plans to make?

Explanation / Answer

cost of equity dividend declare 2.5 growth rate 6% expected dividend 2.65 market price 35 expected dividend/market price)+growth rate cost of equity share 0.135714286 13.5714286 percent Year interest present value @7% present value of cash inflw cost of preferred stock 1 80 0.9345794 74.76636 preference dividend 1.5 2 80 0.8734387 69.8751 market price 19 3 80 0.8162979 65.30383 cost of preference shares 7.8947368 percent 4 80 0.7628952 61.03162 5 80 0.7129862 57.03889 cost of debt 6 80 0.6663422 53.30738 7 80 0.6227497 49.81998 interest 80 8 80 0.5820091 46.56073 market price of bond 1124.0904 9 80 0.5439337 43.5147 tax rate 34% 10 80 0.5083493 40.66794 cost of debt 0.0711687 4.697131071 11 80 0.4750928 38.00742 12 80 0.444012 35.52096 13 80 0.4149644 33.19716 overall cost of capital weight cost weight *cost 14 80 0.3878172 31.02538 15 80 0.362446 28.99568 debt 0.38 4.6971311 1.784909807 16 80 0.3387346 27.09877 preferred 0.15 7.8947368 1.184210526 17 80 0.3165744 25.32595 equity 0.47 13.571429 6.378571429 18 80 0.2958639 23.66911 19 80 0.2765083 22.12067 weighted average cost of capital 9.347691762 20 80 0.258419 20.67352 percent 21 80 0.2415131 19.32105 22 80 0.2257132 18.05705 calculation of flotation cost weight flotation cost 23 80 0.2109469 16.87575 24 80 0.1971466 15.77173 debt 0.38 15.2 0.50% 0.076 25 80 0.1842492 14.73993 preferred 0.15 7.35 2% 0.147 26 80 0.1721955 13.77564 equity 0.47 18.8 5% 0.94 27 80 0.1609304 12.87443 28 80 0.1504022 12.03218 total flotation cost 1.163 29 80 0.1405628 11.24503 million 30 1080 0.1313671 141.8765 firm will need to raise a total of 40+1.163 million from various sources because 1.163 would be spend on raising the fund so total funds would be required would be 41.163 and this floation cost would be amortized over the life of the investment market price of bond 1124.09

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