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, restated 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. a. If the firm is in a 34% tax bracket, what is the weighted average cost of capital (i.e.. Firm WACC)? lx 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, and the common stock issue will require flotation costs of 500 basis points. What are the total flotation costs the firm will incur to raise the needed $40 million? How should the flotation costs be incorporated into the analysis of the $40 million investment the firm plans to make?

Explanation / Answer

Part A

Wd(Bond cost of financing)= 38%; Wp(Preferred Stock Cost of Financing)= 15%; We(Common Stock Cost of Financing)= 47%.

Cost of Debt,Kd= Yield(1- Tax Rate)

                              = 7%(1-0.34)= 4.62%

Cost of Equity, Ke- To calculate cost of equity we will use Dividend Discount model

D0(Dividend paid last year)=$2.5; Current Market Price, P= $35; Growth rate of dividends, g= 6%

As P=D0(1+g)/(Ke-g) we get Ke= 0.1357= 13.57%

Cost of Preferred Stock, Kp= Dividend of Preferred Stock/Net Issuing Price

                                                            =1.5/50= 0.03= 3%

So WACC= WeKe+WdKd+WpKp= 0.47*13.57+0.38*4.62+0.15*3= 8.58%

Part B

Total size of Company= $80 million (as it is mentioned that $40 million-Price of new plant is half of size of company)

New Cost of Debt will be Kd2= 4.62+0.5= 5.12%; Kp2= 3%+2%=5%; Ke2=13.57+5=18.57%

So Floatation cost for New plant will be = WeKe2+WdKd2+WpKp2 = 11.42%

So the new project should have higher rate of return as compared to rest of the projects of the company in order for it to be successful & not be a burden on rest of the company. This is because its cost of capital is 2.84% higher than rest of company.

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