TACC601 Workshop 3 Problem Set

1

The Nealon Manufacturing Company is in the midst of negotiations to acquire a plant in Broken Hill, NSW. The company CFO, James Nealon, is the son of the founder, CEO of the company and heir- apparent to the CEO position, so he is very concerned about making such a large commitment of money to the new plant. The cost of the purchase is $40 million, which is roughly half the size of the company today.

To begin his analysis, James has launched the firm's first-ever cost of capital estimation. Thecompany's current balance sheet, re-stated to reflect market values, has been converted to percentages

as shown in the table below.

The company paid dividends to its ordinary shareholders of $1.75 per share last year, and the projectedrate of annual growth in dividends is 7% per year for the indefinite future. Nealon's ordinary sharestrade over the counter and have a current market price of $35 per share. In addition, the firm's bondshave a BB rating. Moreover, BB bonds are currently yielding 7%. The preference shares have a current market price of $19.

Questions

1. If the firm's tax rate is 30%, what is the weighted average cost of capital (i.e. what is the
2. firm's WACC)?
3. In the analysis done so far we have not considered the effects of flotation costs. Assume now that Nealon is raising a total of $40 million using the above financing mix. New debt financing will require that the firm pay 50 basis points (i.e. 0.5%) in issue costs, the sale of preference shares will require the firm to pay 200 basis points in flotation costs, and the ordinary shares issue will require flotation costs of 500 basis points.
4. What are the total flotation costs that the firm will incur to raise the $40 million needed?
5. How should the flotation costs be incorporated into the analysis of the $40 million investment that the firm plans to make?