1. WestGas Conveyance, Inc., is a large U.S. natural gas pipeline company that wants to raise $120 million to finance expansion.

WestGas wants a capital structure that is 50% debt and 50% equity. Its corporate combined federal and state income tax rate is 40%.

WestGas finds that it can finance in the domestic U.S. capital market at the rates listed below. 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.

US Capital Market Costs:

Amount of Capital Raised	Cost of Equity	Cost of Debt
Up to $40 million of New Capital	12%	8%
$41 million to $80 million of New Capital	18%	12%
Above $80 million	22%	16%

A London bank advises WestGas 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.

European capital market Costs:

Amount of Capital Raised	Cost of Equity	Cost of Debt
Up to $40 million of New Capital	14%	6%
$41 million to $80 million of New Capital	16%	10%
Above $80 million	24%	18%

Each increment of cost would be influenced by the total amount of capital raised. That is, if WestGas 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.

1. Calculate the lowest average cost of capital for each increment of $40 million of new capital, where WestGas raises $20 million in

the equity market and an additional $20 million in the debt market at the same time.

1. If WestGas pans an expansion of only $60 million, how should that expansion be financed? What will be the weighted average cost

of capital for the expansion?

2. The Union Computer Export Company has considered a variety of projects, but all of its business is still in the

United Kingdom. Since most of its business comes from exporting super computers (denominated in sterling),

it remains exposed to exchange rate risk. On the favorable side, the British demand for computers has risen consistently

every year. John Johnson, the owner of the firm, has retained about $10,000,000 (after the sterling was converted

into dollars) in earnings since he began his business. At this point in time, his capital structure is mostly his own

equity, with very little debt. John has periodically considered establishing a subsidiary in the United Kingdom to

produce computers there (so that he would not have to export them from the United States).

If he does establish this subsidiary, he has several options for capital structure that would be used to

support it: (1) use all of his equity to invest in the firm, (2) use sterling denominated long-term debt,

or (3) use dollar denominated long-term debt. The interest rate on British long-term debt is slightly higher

than the interest rate on US long-term debt.

• What is the advantage of using equity to support the subsidiary? What is a disadvantage?
• If John decides to use long-term debt as the primary form of capital to support the subsidiary,

should he use dollar-denominated debt or sterling denominated debt?

• How can the equity proportions of this firm's capital structure increase over time after it is established?