3. Deming Pipelines, Inc. Deming Pipelines, Inc. is a large U.S. natural gas pipeline company that wants to raise $120 million to finance expansion. Deming wants a capital structure that is 50% debt and 50% equity. Its corporate combined federal and state income tax rate is 40%. Deming finds that it can finance in the domestic U.S. capital market at the following rates. Both debt and equity would have to be sold in multiples of $20 million, and these cost figures show the component costs, each, of debt and equity if raised half by equity and half by debt.

A London bank advises Deming that U.S. dollars could be raised in Europe at the following costs, also in multiples of $20 million while maintaining the 50/50 capital structure.

Each increment of cost would be influenced by the total amount of capital raised. That is, if Deming first borrowed $20 million in the European market at 6%

and matched this with an additional $20 million of equity, additional debt beyond this amount would cost 12% in the United States and 10% in Europe. The same relationship holds for equity financing.

a. Calculate the lowest average cost of capital for each increment of $40 million of new capital, where Deming raises $20 million in the equity market and an additional $20 million in the debt market at the same time.

b. If Deming plans an expansion of only $60 million, how should that expansion be financed? What will be the weighted average cost of capital for the expansion?

Transcribed Image Text:

Cost of Domestic Equity Cost of Domestic Debt Up to $40 million of new capital 12% 8% $41 million to $80 million of new capital 18% 12% Above $80 million 16%