Lou Matson, President of Midsouth Exploration Company, knew that circumstances had finally become favorable for drilling for oil in March of 2014. For the last three years conditions had been miserable for oil companies. As the price of oil slipped to $10 a barrel, it was no longer economically feasible to search for new sources of petroleum. However, the booming world economy in the first quarter of 2016, along with restricted output by OPEC and other oil-producing nations, had sent the price of oil to over $30 a barrel.

Midsouth Exploration had extensive holdings in Louisiana and East Texas that had largely gone unattended over the last three years. When Lou Matson called his chief geologist, Harold Boudreaux, the drilling expert quickly informed Matson that all systems were go from an exploration viewpoint.

Raising Capital

However, Midsouth had a problem and that was raising capital to carry out the new exploration. While the firm often formed limited partnerships for specific projects, permanent capital was also required to support the increased operations of the firm. A recent conversation with Arthur Barnes III, the managing director of the investment-banking firm of Barnes, Colson, and Wilson, Inc., lead Mr. Matson to believe that immediate and decisive financing activity was necessary.

Thirty million dollars in new capital needed to be raised as a base for future operations. Because of the risky nature of the firms business, debt financing was out of the question. The investment banker suggested a new common stock issue might be the best alternative, but he also pointed out there was a potential problem.

In 2007, the company had issued $8.50 (dividend) cumulative preferred stock at $100 par value. There were 200,000 shares issued. The company promptly made payments on the preferred stock from 2008 to 2012. However, in the second half of 2013 and in 2014 and 2015 no preferred stock dividends were paid. Mr. Barnes, the investment banker, pointed out that common stock would be difficult to sell with the preferred stock dividend in arrears (unpaid). With cumulative preferred stock,

no dividends can be paid to common stockholders unless all prior dividend claims by preferred stockholders have been satisfied. Of course, current claims must also be met.

Financing Plan

Mr. Barnes investment banking experience led him to believe that any new common stock that Midsouth Exploration Company issued must pay dividends.

He suggested that if Midsouth sold common stock at $25 per share to the public (less $1.20 in flotation costs to the corporation), a $.50 per share common stock dividend would likely be necessary to attract investors.

Mr. Barnes further suggested that instead of attempting to pay all of the preferred stock dividends in arrears, the company offer the old preferred stockholders new preferred stock that is worth 50 percent more than the outstanding preferred stock (which is currently selling for the amount it is totally in arrears). The new preferred stock would pay a 9.2 percent dividend yield.

Because the old preferred stockholders would become new preferred stockholders, they would once again become dividend recipients, and would have a tax obligation related to the annual dividend yield of 9.2 percent.

Cost of Funding

As president of Midsouth Exploration Company, Mr. Matson liked the idea of exchanging new preferred stock for old preferred stock as well as selling new common stock. He was definitely willing to go along with the plan. However, there was one question that bothered him. Being a petroleum engineer, he had no formal business training and that, perhaps, was the reason behind his concern. He wondered why the firm had to pay a 9.2 percent dividend yield on preferred and only a 2 percent dividend yield on common stock ($.50 dividend/$25 stock price). His investment banker explained that the cost of common stock was not simply the cost of the dividend, but the total expected return to stockholders that must be earned to keep them satisfied. He suggested that investors in Midsouth Exploration Company had an expectation that the company would be able to grow at a 9.75 percent rate (g) in the future.

REQUIRED

4. Taking the 9.2 percent annual dividend rate, and assuming a35 percent marginal tax rate for corporate investors, what would thepercentage aftertax yield be on preferred stock for corporateinvestors? Recall that 70 percent of the preferred stock dividend istax exempt to corporate investors and only 30 percent is taxable.

5. Compare the cost of new preferred stock to the cost of new commonstock for the issuing corporation. (See Chapter 11 for formulas).There is no flotation cost on new preferred stock in this case since itis merely being exchanged for old preferred stock.Are there any tax benefits for the issuing corporation with eithersecurity?

6. Under the proposed financing plan to raise $30 million in newfunds, how many new shares of common stock must be issued?The out-of-pocket costs will be $250,000, while the underwriting spread (flotation cost) is $1.20.