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 $90 million.

To finance the new facility, Nealon has $30 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 $60million. 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 the 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,

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SOURCE OF FINANCING	TARGET CAPITAL STRUCTURE WEIGHTS
Bonds	40 %
Common stock	60 %

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

$1,000per bond, carry a coupon rate of 99percent, have 16 years to maturity, and are selling for $1,050.

Nealon's common stock has a current market price of $ 34, and the firm paid a $2.20dividend last year that is expected to increase at an annual rate of 88percent 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 35 percent for your estimate) and flotation costs of $40per bond have been considered?

Note : Use N=16 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 $2.00 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, $30 million in retained earnings and $60million 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 40percent of the $90 million in new capital, or $36 million, using $30 million in retained earnings and raising $24 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

Solution:

a. The bond's yield to maturity is calculated using the financial calculator:

16	8.42%	90	1050	1000	Enter
N	I/Y	PMT	PV	FV

The bond's yield to maturity is 8.42%

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b. Now we calculate the cost of debt financing using financial calculator

16	8.88%	90	1050-40=1010	1000	Enter
N	I/Y	PMT	PV	FV

Therefore, the cost of new debt financing before tax is 8.88% and after-tax cost of new debt financing is 8.88% *(1 - 0.35) = 5.77%.

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c. The cost of new equity financing raised from the sale of common stock is calculated as follows

Cost of new equity = Expected dividend/Net proceeds per share+ Growth rate

Cost of new equity = $2.20 (1.08)/($34 - $2) + 0.08

Cost of new equity = $2.376/$32 + 0.08

Cost of new equity = 0.15425 or 15.425%

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d. For calculating weighted average cost of capital (WACC), we calculate the cost of retained earnings

Cost of retained earnings = $2.20(1.08)/$34 + 0.08

Cost of retained earnings = $2.376/$34 + 0.08

Cost of retained earnings = 0.1499 or 14.99%

WACC = Proportion of bonds*Cost of bonds + Proportion of retained earnings*Cost of retained earnings

WACC = (60/(60+30))*5.77% + (30/(60+30)*14.99%

WACC = 8.84%

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e. WACC = Proportion of bonds*Cost of bonds + Proportion of retained earnings*Cost of retained earnings + Proportion of equity*Cost of equity

WACC = 0.40*5.77% + (30/90)*14.99% + (24/90)*15.425%

WACC = 0.1142 or 11.42%

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f. Since the company optimum capital structure is in the debt to equity ratio of 40:60, the cost of capital calculated in (e) is 11.42% should be considered to evaluate the new investment opportunity.

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f.