Nealon Energy Corporation engages in the acquisition, exploration, development, and production of natural gas and oil in the continental United States. The company has grown rapidly over the last 5 years as it has expanded into horizontal drilling techniques for the development of the massive deposits of both gas and oil in shale formations. The company's operations in the Haynesville shale (located in northwest Louisiana) have been so significant that it needs to construct a natural gas gathering and processing center near Bossier City, Louisiana, at an estimated cost of $50 million. To finance the new facility, Nealon has $10 million in profits that it will use to finance a portion of the expansion and plans to sell a bond issue to raise the remaining $40 million. The decision to use so much debt financing for the project was largely due to the argument by company CEO Douglas Nealon Sr. that debt financing is relatively cheap relative to common stock (which the firm has used in the past). Company CFO Doug Nealon Jr. (son of the company founder) did not object to the decision to use all debt but pondered the issue of what cost of capital to use for the expansion project. There was no doubt that the out-of-pocket cost of financing was equal to the new interest that must be paid on the debt. However, the CFO also knew that by using debt for this project the firm would eventually have to use equity in the future if it wanted to maintain the balance of debt and equity it had in its capital structure and not become overly dependent on borrowed funds.

The following balance sheet,

SOURCE OF FINANCING TARGET CAPITAL STRUCTURE WEIGHTS

Bonds 30%

Common stock 70%

reflects the mix of capital sources that Nealon has used in the past. Although the percentages would vary over time, the firm tended to manage its capital structure back toward these proportions.

The firm currently has one issue of bonds outstanding. The bonds have a par value of $1,000

per bond, carry a coupon rate of 6 percent, have 6 years to maturity, and are selling for $1,065.

Nealon's common stock has a current market price of $26, and the firm paid a $2.80

dividend last year that is expected to increase at an annual rate of 6 percent for the foreseeable future.

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

b. What is the cost of new debt financing to Nealon based on current market prices after both taxes (you may use a marginal tax rate of 27 percent for your estimate) and flotation costs of $35 per bond have been considered?

Note:

Use

N=6

for the number of years until the new bond matures.

c. What is the investor's required rate of return for Nealon's common stock? If Nealon were to sell new shares of common stock, it would incur a cost of

$5.00

per share. What is your estimate of the cost of new equity financing raised from the sale of common stock?

d. Compute the weighted average cost of capital for Nealon's investment using the weights reflected in the actual financing mix (that is,

$10

million in retained earnings and

$40

million in bonds).

e. Compute the weighted average cost of capital for Nealon where the firm maintains its target capital structure by reducing its debt offering to

30

percent of the

$50

million in new capital, or

$15

million, using

$10

million in retained earnings and raising

$25

million through a new equity offering.

f. If you were the CFO for the company, would you prefer to use the calculation of the cost of capital in part d or e to evaluate the new project? Why?