Question

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 36​%. 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	19%	13%	17%	12%
Above $80 million	21%	15%	23%	17%

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 13​% in the United States and 12​% 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 the​expansion?

Answer 1

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