Question

Nealon Energy Corporation engages in the​ acquisition, exploration,​ development, and production of natural gas and oil in the continental United States. The company has grown rapidly over the last 5 years as it has expanded into horizontal drilling techniques for the development of the massive deposits of both gas and oil in shale formations. The​ company's operations in the Haynesville shale​ (located in northwest​ Louisiana) have been so significant that it needs to construct a natural gas gathering and processing center near Bossier​ City, Louisiana, at an estimated cost of ​$80 million. To finance the new​ facility, Nealon has ​$20 million in profits that it will use to finance a portion of the expansion and plans to sell a bond issue to raise the remaining ​$60 million. The decision to use so much debt financing for the project was largely due to the argument by company CEO Douglas Nealon Sr. that debt financing is relatively cheap relative to common stock​ (which the firm has used in the​ past). Company CFO Doug Nealon Jr.​ (son of the company​ founder) did not object to the decision to use all debt but pondered the issue of what cost of capital to use for the expansion project. There was no doubt that the​ out-of-pocket cost of financing was equal to the new interest that must be paid on the debt.​ However, the CFO also knew that by using debt for this project the firm would eventually have to use equity in the future if it wanted to maintain the balance of debt and equity it had in its capital structure and not become overly dependent on borrowed funds. The following balance​ sheet, Bonds = 30% Common Stock = 70% reflects the mix of capital sources that Nealon has used in the past. Although the percentages would vary over​ time, the firm tended to manage its capital structure back toward these proportions. The firm currently has one issue of bonds outstanding. The bonds have a par value of ​$1,000 per​ bond, carry a coupon rate of 8 ​percent, have 14 years to​ maturity, and are selling for ​$1,070. ​Nealon's common stock has a current market price of $ 36​, and the firm paid a ​$2.60 dividend last year that is expected to increase at an annual rate of 6 percent for the foreseeable future. a. What is the yield to maturity for​ Nealon's bonds under current market​ conditions? b. What is the cost of new debt financing to Nealon based on current market prices after both taxes​ (you may use a marginal tax rate of 34 percent for your​ estimate) and flotation costs of ​$30 per bond have been​ considered? Note​: Use N= 14 for the number of years until the new bond matures. c. What is the​ investor's required rate of return for​ Nealon's common​ stock? If Nealon were to sell new shares of common​ stock, it would incur a cost of ​$3.50 per share. What is your estimate of the cost of new equity financing raised from the sale of common​ stock? d. Compute the weighted average cost of capital for​ Nealon's investment using the weights reflected in the actual financing mix​ (that is, ​$20 million in retained earnings and ​$60 million in​ bonds). e. Compute the weighted average cost of capital for Nealon where the firm maintains its target capital structure by reducing its debt offering to 30 percent of the ​$80 million in new​ capital, or ​$24 ​million, using ​$20 million in retained earnings and raising ​$36 million through a new equity offering. f. If you were the CFO for the​ company, would you prefer to use the calculation of the cost of capital in part ​(d​) or ​(e​) to evaluate the new​ project? Why?

Answer 1

a. What is the yield to maturity for​ Nealon's bonds under current market​ conditions?

YTM = RATE (Period, PMT, PV, FV) = RATE (14, 8% x 1000, -1070, 1000) = 7.19%

b. What is the cost of new debt financing to Nealon based on current market prices after both taxes​ (you may use a marginal tax rate of 34 percent for your​estimate) and flotation costs of ​$30 per bond have been​considered? Note​: Use N= 14 for the number of years until the new bond matures.

Cost of new debt financing = RATE (Period, PMT, PV, FV) x (1 - Tax rate) = RATE (14, 8% x 1000, -(1070 - 30), 1000) x (1 - 34%) = 4.97%

c. What is the​ investor's required rate of return for​ Nealon's common​ stock?

Ke = D0 x (1 + g) / P + g = 2.6 x (1 + 6%) / 36 + 6% = 13.66%

If Nealon were to sell new shares of common​ stock, it would incur a cost of ​$3.50 per share. What is your estimate of the cost of new equity financing raised from the sale of common​ stock?

Ke = D0 x (1 + g) / (P - F) + g = 2.6 x (1 + 6%) / (36 - 3.50) + 6% = 14.48%

d. Compute the weighted average cost of capital for​ Nealon's investment using the weights reflected in the actual financing mix​ (that is, ​$20 million in retained earnings and ​$60 million in​ bonds).

WACC = Proportion of debt x After tax cost of debt + Proportion of retained earnings x Cost of retained earnings = 60 / 80 x 4.97% + 20 / 80 x 13.66% = 7.14%

e. Compute the weighted average cost of capital for Nealon where the firm maintains its target capital structure by reducing its debt offering to 30 percent of the ​$80 million in new​ capital, or ​$24 ​million, using ​$20 million in retained earnings and raising ​$36 million through a new equity offering.

WACC = 24/80 x 4.97% + 20/80 x 13.66% + 36/80 x 14.48% = 11.42%

f. If you were the CFO for the​ company, would you prefer to use the calculation of the cost of capital in part ​(d​) or​(e​) to evaluate the new​ project? Why?

I will prefer option (d).

Reasons:

• A project should be evaluated using the project specific cost of capital and not the overall cost of capital of the firm.
• Evaluating a project at firm's cost of capital may lead to rejection of otherwise positive NPV project or selection of otherwise negative NPV projects