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 $90 million.

To finance the new facility, Nealon has $30 million in profitsthat it will use to finance a portion of the expansion and plans tosell a bond issue to raise the remaining $60million. 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 the companyfounder) did not object to the decision to use all debt butpondered the issue of what cost of capital to use for the expansionproject. There was no doubt that the out-of-pocket cost offinancing 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 the equity in thefuture if it wanted to maintain the balance of debt and equity ithad in its capital structure and not become overly dependent onborrowed 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 thepast. Although the percentages would vary over time, the firmtended to manage its capital structure back toward theseproportions.

The firm currently has one issue of bonds outstanding. The bondshave a par value of

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

Nealon's common stock has a current market price of $ 34, andthe firm paid a $2.20dividend last year that is expected toincrease at an annual rate of 88percent for the foreseeablefuture.

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

b.What is the cost of new debt financing toNealon based on current market prices after both taxes (you may usea marginal tax rate of 35 percent for your estimate) and flotationcosts of $40per bond have been considered?

Note : Use N=16 for the number ofyears until the new bond matures.

c.What is the investor's required rate ofreturn for Nealon's common stock? If Nealon were to sell new sharesof common stock, it would incur a cost of $2.00 per share. What isyour estimate of the cost of new equity financing raised from thesale of common stock?

d.Compute the weighted average cost of capitalfor Nealon's investment using the weights reflected in the actualfinancing mix (that is, $30 million in retained earnings and$60million in bonds).

e.Compute the weighted average cost of capitalfor Nealon where the firm maintains its target capital structure byreducing its debt offering to 40percent of the $90 million in newcapital, or $36 million, using $30 million in retained earnings andraising $24 million through a new equity offering.

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