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    Cost of capital

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    Mini Case

    The balance sheet that follows indicates the capital structures 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 Percentage of Future Financing
    Bonds (8%, 1,000 par 16-year maturity) 38%
    Preferred stock (5,000 shares outstanding,
    $50 par, $1.50 dividend) 15%
    Common equity 47%
    Total -------
    100%

    A) 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.
    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. 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. Under these terms, the new shares should provide net proceeds of about $32.55. 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?

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    Solution Summary

    The solution explains the calculation of component costs of capital and the WACC.

    $2.19

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