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Question:-

The balance sheet that follows indicates the capital structure for Nealon Inc. Flotation
costs are (a) 15 percent of market value for a new bond issue, and (b) $2.01 per share for
preferred stock. The dividends for common stock were $2.50 last year and are projected
to have an annual growth rate of 6 percent. The firm is in a 34 percent tax bracket. What
is the weighted average cost of capital if the firm's finances are in the following
proportions?
Type of financing % of future financing

Bonds (8%, $1000 par, 16-yr mat) 38%

Preferred stock (5,000 shares


outstanding, $50 par, $1.50 dividend) 15%

Common equity 47%


Total 100%

Market prices are $1,035 for bonds, $19 for preferred stock, and $35 for common
stock. There will be sufficient internal common equity funding (i.e., retained
earnings) available such that the firm does not plan to issue new common stock.
Calculate the firm's weighted average cost of capital using Excel.

Solution:- Computation of the WACC

WACC =

WACC = Equity Preffered


Total Value X Ke X Total Value X

Computation of the cost of Debt

Coupon interest 80
Price 879.75
Par Value 1,000
Maturity 16 years
YTM 9.49%
After tax cost 6.26%

Hence the After tax cost of debt is 6.26%


Cost of preferred stock – The preferred stock is perpetuity and the cost is given as
Cost of preferred stock = Annual dividend/(Price – Flotation cost)

Annual dividend = $1.50


Price = $19
flotation cost is $2.01

Cost of preferred stock = 0.0882872278

Hence the cost of the Preferred stock is 8.83%

Cost of retained earnings – Since dividends are growing at a constant rate, we use the constant growth formula to find the cos

Cost of retained earnings = D1/P0 + g


where
D1 = expected divide 2.65
P0 = current price = 35
g = growth rate = 6 6%

Cost of retained earnings = 13.57%

ence the cost of retained earning is 13.57%

WACC = Equity Preffered


Total Value X Ke X Total Value X

WACC = 0.100812

Hence the WACC is 10.08%

b. In part a we assumed that Nealon would have sufficient retained earnings such that it would not need to sell
additional common stock to finance its new investments. Consider the situation now, when Nealon's retained
earnings anticipated for the coming year are expected to fall short of the equity requirement of 47 percent of
new capital raised. Consequently, the firm foresees the possibility that new common shares will have to be
issued. To facilitate the sale of shares, Nealon's investment banker has advised management that they should
expect a price discount of approximately 7 percent, or $2.45 per share. What is Nealon's cost of equity capital
when new shares are sold, and what is the weighted average cost of the added funds involved in the issuance of
new shares? Please use Excel to calcul

Solution:- Computation of the WACC


Cost of new shares takes into account the flotation cost and is given as
Cost of new equity = D1/(P0-F) + g
where
D1 = expected dividend = $2.65 (calculated earlier)
P0 = Price = $35
F = flotation cost = $2.45 and g = growth rate = 6%

Cost of new equity = 14.14%

WACC = Equity Preffered


Total Value X Ke X Total Value X

WACC = 0.103491

Hence the WACC is 10.35%


Debt
Kp X Total Value X Kd(1-T)
tant growth formula to find the cost

Debt
Kp X Total Value X Kd(1-T)

would not need to sell


when Nealon's retained
ment of 47 percent of
shares will have to be
ment that they should
s cost of equity capital
olved in the issuance of
Debt
Kp X Total Value X Kd(1-T)
Coupon interest 80
Price 879.75
Par Value 1,000
Maturity 16 years
YTM 9.49%
After tax cost 6.26%