In: Finance
WestGas Conveyance, Inc., is a large U.S. natural gas pipeline company that wants to raise $120 million to finance expansion. WestGas wants a capital structure that is 50% debt and 50% equity. Its corporate combined federal and state income tax rate is 30%. WestGas finds that it can finance in the domestic U.S. capital market at the rates listed:
Costs of Raising Capital in the Market | Cost of Domestic Equity |
Cost of Domestic Debt |
Cost of European Equity |
Cost of European Debt |
Up to $40 million of new capital | 12% | 9% | 14% | 8% |
$41 million to $80 million of new capital | 18% | 11% | 16% | 10% |
Above $80 million | 23% | 16% | 24% | 18% |
Both debt and equity would have to be sold in multiples of $20 million, and these cost figures show the component costs, each, of debt and equity if raised 50% by debt and 50% by equity. A London bank advises WestGas that U.S. dollars could be raised in Europe at the following costs, also in multiples of $20 million, while maintaining the 50/50 capital structure.
Each increment of cost would be influenced by the total amount of capital raised. That is, if WestGas first borrowed $20 million in the European market at 8% and matched this with an additional $20 million of equity, additional debt beyond this amount would cost 11% in the United States and 10% in Europe. The same relationship holds for equity financing.
a. Calculate the lowest average cost of capital for each increment of $40 million of new capital, where WestGas raises $20 million in the equity market and an additional $20 in the debt market at the same time.
b. If WestGas plans an expansion of only $60 million, how should that expansion be financed? What will be the weighted average cost of capital for theexpansion?
Answer to a
We see that
Cost of raising the 1st $20 Million in the US Debt Market is 9*(100-36)=5.76%
Cost of raising the 1st $20 Million in the US Equity Market is 12%.
Therefore combined weighted average capital Cost of $40 Million in US Market= 12+5.76 = 17.76%
Cost of raising the 1st $20 Million in the Euro Debt Market is 8*(100-36)=5.12%
Cost of raising the 1st $20 Million in the Euro Equity Market is 14%.
Therefore combined weighted average capital Cost of $40 Million in Euro Market= 14+5.12 = 19.12%
WestGas Conveyance, Inc., should therefore raise $40 Million from the US Market.
Answer to B
We see that cost of Debt and Equity Post raising of initial $40 Million is cheaper in Europe Market.
Therefore
Amount |
Markets |
Debt |
Post Tax Debt |
Equity |
WCC |
||||||||
First 40 Miilion |
US |
9.00 |
5.76 |
12.00 |
17.76 |
||||||||
Expansion |
40 Million |
Europe |
12.00 |
7.68 |
17.00 |
24.68 |
|||||||
20 Million |
US |
7.50 |
4.80 |
10.50 |
15.30 |
(This is 50% of Cost as mentioned as we are only rasing 10 Million) |
|||||||
Weighted Average Cost of Capital for the entire $100 Million |
20.04 |
Working of the same is below:-
Amount |
Markets |
Debt |
Post Tax Debt |
Equity |
WCC |
|
First 40 Miilion |
US |
9 |
=I5*64% |
12 |
=K5+J5 |
|
Expansion |
40 Million |
Europe |
12 |
=I6*64% |
17 |
=K6+J6 |
20 Million |
US |
7.5 |
=I7*64% |
10.5 |
=K7+J7 |
|
Weighted Average Cost of Capital for the entitre $100 Million |
=0.4*L5+0.4*L6+0.2*L7 |