The Nealon Manufacturing Company is in the midst of negotiations to acquire a plant in Fargo, North

Dakota. The company CFO, James Nealon, is the son of the founder and 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 one -half the size of
the company today.
To begin his analysis, James has launched the firm’s first ever cost -of – capital estimation. The
company’s current balance sheet, restated to reflect market values, has been converted to percentages
as follows:
Nealon, Inc., Balance Sheet—2013
Type of Financing
Percentage of Future Financing
Bonds (8%, $1,000 par, 30 – year maturity) 38%
Preferred stock (5,000 shares outstanding, $50 par, $1.50 dividend) 15%
Common stock 47%
Total 100%

The company paid dividends to its common stockholders of $2.50 per share last year, and the
projected rate of annual growth in dividends is 6 percent per year for the indefinite future. Nealon’s
common stock trades over the counter and has a current market price of $35 per share. In addition, the
firm’s bonds have an AA rating. Moreover, AA bonds are currently yield ing 7 percent. The preferred
stock has a current market price of $19 per share.

a. If the firm is in a 34 percent tax bracket, what is the weighted average cost of capital (i.e., firm
WACC)?
b. 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., o ne -half a percent) in issue costs, the sale of preferred stock
will
require the firm t o pay 200 basis points in flotation costs, and the common stock issue will require
flotation costs of 500 basis points.
i. What are the total flotation costs the fir m will incur to raise the needed $40 million?
ii. How should the flotation costs be incorporated into the analysis of the $40 million investment the
firm plans to make?

Need Solution problem Nealon Manufacturing Company

To calculate the weighted average cost of capital (WACC) for Nealon Manufacturing Company, we need to consider the weights of each type of financing (bonds, preferred stock, and common stock) and their respective costs.


a. Here's how to calculate the firm WACC:

Step 1: Calculate the after-tax cost of debt:
- The bonds have an 8% coupon rate and an AA rating.
- Since the tax bracket is 34%, we need to calculate the after-tax cost of debt.
- The after-tax cost of debt = Pre-tax cost of debt * (1 - Tax rate)
- Pre-tax cost of debt = coupon rate = 8%
- After-tax cost of debt = 8% * (1 - 0.34) = 5.28%

Step 2: Calculate the cost of preferred stock:
- The preferred stock has a dividend of $1.50 per share and a market price of $19 per share.
- The cost of preferred stock can be calculated using the formula: Dividend / Market price
- Cost of preferred stock = $1.50 / $19 = 7.89%

Step 3: Calculate the cost of equity (common stock):
- The cost of equity can be calculated using the Capital Asset Pricing Model (CAPM).
- We need the risk-free rate, market risk premium, and the beta of the company.
- Since these values are not provided in the question, we'll assume them for the calculation.
- Let's assume the risk-free rate = 2.5%, market risk premium = 6%, and beta = 1.2.
- Cost of equity = Risk-free rate + Beta * Market risk premium
- Cost of equity = 2.5% + 1.2 * 6% = 9.7%

Step 4: Calculate the weights of each type of financing:
- Given in the question: Bonds = 38%, Preferred stock = 15%, Common stock = 47%

Step 5: Calculate the weighted average cost of capital (WACC):
- WACC = Weight of debt * Cost of debt + Weight of preferred stock * Cost of preferred stock + Weight of equity * Cost of equity
- WACC = (38% * 5.28%) + (15% * 7.89%) + (47% * 9.7%)
- WACC = 2.0064% + 1.1835% + 4.579%
- WACC ≈ 7.77%

Therefore, the weighted average cost of capital (WACC) for Nealon Manufacturing Company is approximately 7.77%.

b. Now, let's consider the effects of flotation costs on raising the needed $40 million:

i. Flotation costs for each type of financing:
- Debt financing: 0.5% (50 basis points)
- Preferred stock: 2% (200 basis points)
- Common stock: 5% (500 basis points)

To calculate the total flotation costs for the firm, we need to multiply these percentages by the respective amounts raised.

Flotation costs for Debt financing = 0.005 * (38% * $40 million) = $760,000
Flotation costs for Preferred stock = 0.02 * (15% * $40 million) = $120,000
Flotation costs for Common stock = 0.05 * (47% * $40 million) = $940,000

Total flotation costs = $760,000 + $120,000 + $940,000 = $1,820,000

Therefore, the total flotation costs the firm will incur to raise the needed $40 million is $1,820,000.

ii. Flotation costs should be incorporated into the analysis of the $40 million investment by reducing the amount available for investment.

Net amount available for investment = Total amount raised - Total flotation costs
Net amount available for investment = $40 million - $1,820,000 = $38,180,000

The firm should consider only $38,180,000 for the investment instead of the full $40 million when evaluating the project.