Wyoming Energy Development, Inc.

In May 2011, Linda Bellich, a recent MBA graduate and newly appointed assistant to the comptroller of Wyoming Energy Development, Inc (WED), was given a list of six new investment projects proposed for the following year. It was her job to analyze these projects and be prepared to present her findings before the board of directors at its annual meeting to be held in 10 days.

Wyoming Energy Development was founded in Laramie, Wyoming, in 1983 by Scott Heywood. WED gained recognition as a leading producer of high quality coal, with majority of its sales being made to South Korea. During the rapid economic expansion of South Korea in the 1980s, demand for coal and other energy products boomed, and WEDs sales grew rapidly. As a result of this rapid growth and recognition of new opportunities in the energy market, WED began to diversify its product line. While retaining its emphasis on coal production, it expanded operations to include uranium mining and the production of electrical generators, and finally, it went into all phases of energy production. By 2010, WEDs sales had reached the $140 million level, with net profit after taxes attaining a record $6.7 million.

As WED expanded its product line in the early 2000s, it also formalized its capital budgeting procedure. Until 2002, capital investment projects were selected primarily on the basis of the average return on investment calculations, with individual departments submitting these calculations for projects falling within their division. In 2006, the procedure was replaced by one using present value as the decision-making criterion. This change was made to incorporate cash flows rather than accounting profits into the decision-making analysis, in addition to adjusting these flows for the time value of money. At that time, the cost of capital for WED was determined to be 4.36 percent, which has been used as the discount rate for the past five years. This rate was determined by taking a weighted average of the costs WED had incurred in raising funds from the capital markets over the previous 10 years.

It was originally been Bellichs assignment to update this rate over the most recent 10- year period and determine the net present value of all the proposed investment opportunities using this newly calculated figure. However, she objected to this procedure, stating that while this calculation have a good estimate of the past cost of capital, changing interest rates and stock prices made this calculation of little value in the present. Bellich suggested that current costs of raising funds in the capital markets be weighted by their percentage makeup of the capital structure. This proposal was reviewed enthusiastically by the comptroller of WED, and Bellich was given an assignment of recalculating WEDs cost of capital and providing a written report for the board of directors explaining and justifying this calculation.

To determine a weighted average cost of capital for WED, it was necessary for Linda Bellich to examine the costs associated with each source of funding used. In the past, the largest source of funding had been the issuance of new common stock and internally generated funds. Through conversations with the comptroller and other members of the board of directors, Bellich learned that the firm, in fact, wished to maintain its current capital structure since which was in accordance with the book value weights shown in Exhibit 1. She further determined that the strong growth patterns that WED had exhibited over the past 10 years were expected to continue indefinitely because of the dwindling supply of US and Korean domestic oil and the growing importance of, and US and Korean dependence on, coal and other alternative energy resources. Through further investigation, Bellich learned that WED could issue additional shares of common stock, which had a par value of $25 per share and were selling at a current market price of $40. The expected dividend for the next period would be $2 per share, with expected growth at a rate of 6 percent per year for the foreseeable future. The underwriting commission paid to WEDs investment banker would amount to $2 per share and would be for insuring the issue against the risk of adverse market fluctuations in the stocks selling price during the distribution process, in addition to performing the function of actually selling the security and providing advice as to the timing and pricing of the issue.

Companys currently outstanding preferred stock trades in the market for $93.33 per share with a par value of $100 per share and has a stated dividend yield of 7 percent. (This stock pays $7 dividend, 7 percent of par value, forever.) If necessary, with the help of an investment banker, WED could issue additional shares of preferred stock at the current market price with similar par value and dividend yield as the currently outstanding preferred shares. However, the investment banker would charge a fee equal to the 3 percent of the price at which these shares are issued for his help in marketing the issue with the remainder of the funds going to WED.

Finally, Bellich learned that it would be possible for WED to raise an additional $1 million through a one-year loan from WEDs Philadelphia bank at 4 percent, which is the interest rate on companys currently outstanding short-term debt. Any amount raised over $1 million would cost WED 9 percent. Short-term debt has always been used by WED to finance capital expenditures, and as WED grows, it is expected to maintain its proportion in the capital structure to support capital expansion.

Also, $6 million could be raised through a bond issue with 30-year maturity with a 10 percent coupon at 97.5 percent of face value. On this issue, 2 percent of the face value would be charged as an underwriting commission. If it became necessary to raise more funds via long-term debt, $3 million more could be accumulated through the issuance of additional 30-year bonds

sold at 95.5 percent of face value, with the coupon rate being raised to 11 percent and 2 percent of the face value being charged as an underwriting commission. While any additional funds raised via long-term debt would necessarily have a 30-year maturity with 14 percent coupon rate and be sold at 95.4 percent of face value, 2 percent of this face value would be charged as an underwriting fee. Here again, this fee would go to the investment banker for his help in marketing the issue. All these bond issues would pay coupons on semiannual basis. Companys currently outstanding long-term bonds have 20 years of remaining maturity with a 10 percent semiannual coupon and trade at 98 percent of face value in the market.

In the past, WED has calculated a weighted average of these sources of funds to determine its cost of capital. In discussion with the current comptroller, the point was raised that while this served as an appropriate calculation for externally generated funds, it did not take into account the fact that much of the funds used for capital expenditures by WED were internally generated. For example, WED is expected to produce $5 million of internally generated funds in addition to retaining $4 million of its earnings during the coming period. The comptroller agreed that there should be some cost associated with retained earnings financing incorporated into the calculations, but the cost of internally generated funds should not be included since they, as opposed to all other financing methods, do not appear on the liability side of the balance sheet. Although Bellich was not completely convinced by the comptrollers logic, she continued with her work.

QUESTION:

5. If the projects being selected by WED have a higher degree of risk than current projects do, what

   will happen to the cost of capital over time? If projects being selected have less risk than current

   projects do, what will happen to the cost of capital over time?

6. How might a change in the long-term interest rate (a change upward or a change downward)

   affect the marginal cost of equity capital and the overall marginal cost of capital?

EXHIBIT 1 Wyoming Energy Development, Inc. Balance Sheet for Year Ending April 30, 1991 Assets Cash Account receivable Inventories Total current assets Net fixed assets Goodwill Total assets $ 9,000,000 31,000,000 12,000,000 $ 52,000,000 193,000,000 7,000,000 $252,000,000 Liabilities and Equity Accounts payable $ 850,000 Current (short-term) ebt 10,000,000 Accrued taxes 1,150,000 Total current liabilities $ 12,000,000 Long-term debt 75,000,000 Preferred stock 40,000,000 Common stock 114,000,000 Retained earnings 11,000,000 Total liabilities and equity $252,000,000 EXHIBIT 1 Wyoming Energy Development, Inc. Balance Sheet for Year Ending April 30, 1991 Assets Cash Account receivable Inventories Total current assets Net fixed assets Goodwill Total assets $ 9,000,000 31,000,000 12,000,000 $ 52,000,000 193,000,000 7,000,000 $252,000,000 Liabilities and Equity Accounts payable $ 850,000 Current (short-term) ebt 10,000,000 Accrued taxes 1,150,000 Total current liabilities $ 12,000,000 Long-term debt 75,000,000 Preferred stock 40,000,000 Common stock 114,000,000 Retained earnings 11,000,000 Total liabilities and equity $252,000,000