Petro-U.K. (U.K.). Petro-U.K. is a British energy firm that needs to raise £150 million to finance expansion projects. Suppose that Petro-U.K. is seeking a capital structure comprising 30% debt and 70% equity. The corporate tax rate in the U.K. is 21%. Petro-U.K. finds that it can raise finance in the domestic London stock market as follows: both debt and equity would have to be sold in multiples of £50 million (30% debt and 70%

equity). For equity and debt respectively, the financing costs are 8% and 6% on the U.K. market and 10% and 8% on the Latin American market.

A consultancy firm advises Petro-U.K. that incremental finance could be raised in multiples of £50 million

(maintaining the 30/70 capital structure). Each increment of cost would be influenced by the total amount of capital raised.

For equity and debt respectively, the first increment of £50 million (30% debt and 70% equity) would cost 10% and 8% on the U.K. market and 12% and 10% on the Latin American market. The second increment of £50 million would cost 12% and 10% on the U.K. market and 16% and 14% on the Latin American market.

a. Calculate the lowest average cost of capital for each increment of £150 million of new capital, where Petro-U.K. raises £45 million in the equity market and an additional £105 million in the debt market at the same time.

b. If Petro-U.K. plans an expansion of only £75 million, how should that expansion be financed? What will be the weighted average cost of capital for the expansion?