FIN325 / Corporate Finance, Assignment 2- case 3

| October 3, 2018

Case 3.
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.
FIN325 / Corporate Finance, Assignment #2
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?

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