Nealon Energy Corporation engages in the? acquisition,exploration,? development, and production of natural gas and oil inthe continental United States. The company has grown rapidly overthe last 5 years as it has expanded into horizontal drillingtechniques for the development of the massive deposits of both gasand oil in shale formations. The? company's operations in theHaynesville shale? (located in northwest? Louisiana) have been sosignificant that it needs to construct a natural gas gathering andprocessing center near Bossier? City, Louisiana, at an estimatedcost of $50 Million.
To finance the new? facility, Nealon has $10 Million in profitsthat it will use to finance a portion of the expansion and plans tosell a bond issue to raise the remaining $40 million. The decisionto use so much debt financing for the project was largely due tothe argument by company CEO Douglas Nealon Sr. that debt financingis relatively cheap relative to common stock? (which the firm hasused in the? past). Company CFO Doug Nealon Jr.? (son of thecompany? founder) did not object to the decision to use all debtbut pondered the issue of what cost of capital to use for theexpansion project. There was no doubt that the? out-of-pocket costof financing was equal to the new interest that must be paid on thedebt.? However, the CFO also knew that by using debt for thisproject the firm would eventually have to use equity in the futureif it wanted to maintain the balance of debt and equity it had inits capital structure and not become overly dependent on borrowedfunds. The following balance sheet, reflects the mix of capitalsources that Nealon has used in the past. Although the percentageswould vary over? time, the firm tended to manage its capitalstructure back toward these proportions.
The firm currently has one issue of bonds outstanding. The bondshave a par value of $1000 per bond, carry a coupon rate of 6%, have16 years to maturity, and are selling for $1055. Nealon's commonstock has a current market price of $42, and the firm paid a $2.20dividend last year that is expected to increase at an annual rateof 6% for the foreseeable future.
BONDS 40%
COMMON STOCK 60%
a. What is the yield to maturity for? Nealon's bonds undercurrent market? conditions?
b. What is the cost of new debt financing to Nealon based oncurrent market prices after both taxes? (you may use a marginal taxrate of 36% for your? estimate) and flotation costs of $30 per bondhave been considered?
Note?: Use N=16 for the number of years until the new bondmatures.
c. What is the? investor's required rate of return for? Nealon'scommon? stock? If Nealon were to sell new shares of common? stock,it would incur a cost of
$3.00 per share. What is your estimate of the cost of new equityfinancing raised from the sale of common?stock?
d. Compute the weighted average cost of capital for? Nealon'sinvestment using the weights reflected in the actual financingmix?(that is,
$10 million in retained earnings and $40 million in? bonds).
e. Compute the weighted average cost of capital for Nealon wherethe firm maintains its target capital structure by reducing itsdebt offering to 40 percent of the
$50 million in new? capital, or $20
?million, using $20 million in retained earnings and raising $10million through a new equity offering.
f. If you were the CFO for the? company, would you prefer to usethe calculation of the cost of capital in part (d?) or (e?) toevaluate the new? project? Why?
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