Question

WestGas Conveyance, Inc., is a large U.S. natural gas pipeline company that wants to raise $120 million to finance expansion. WestGas wants a capital structure that is 50% debt and 50% equity. Its corporate combined federal and state income tax rate is 40%. WestGas finds that it can finance in the domestic U.S. capital market at the rates listed below. Both debt and equity would have to be sold in multiples of $20 million, and these cost figures show the component costs, each, of debt and equity if raised 50% by debt and 50% by equity. A London bank advises WestGas that U.S. dollars could be raised in Europe at the following costs, also in multiples of $20 million, while maintaining the 50/50 capital structure. Each increment of cost would be influenced by the total amount of capital raised. That is, if WestGas first borrowed $20 million in the European market at 5% and matched this with an additional $20 million of equity, additional debt beyond this amount would cost 11% in the United States and 10% in Europe. The same relationship holds for equity financing.

a. Calculate the lowest average cost of capital for each increment of $40 million of new capital, where WestGas raises $20 million in the equity market and an additional $20 in the debt market at the same time.

b. If WestGas plans an expansion of only $60 million, how should that expansion be financed? What will be the weighted average cost of capital for the expansion?

Rates:

Cost of Domestic Equity	Cost of Domestic Debt	Cost of European Equity	Cost of European Debt
Up to​ $40 million of new capital	12​%	7​%	13​%		5​%
​ $41 million to​ $80 million of new capital	17​%	11​%	15​%		10​%
Above​ $80 million	23​%	15​%	24​%		16​%

Answer 1

Tax rate

40%

	Cost of	Cost of	After tax Cost of	Cost of	Cost of	After tax Cost of
	Domestic	Domestic	Domestic	European	European	European
	Equity	Debt	Debt	Equity	Debt	Debt
Up to​ $40 million of new capital	12%	7%	4.20%	13%	5%	3.00%
​ $41 million to​ $80 million of new capital	17%	11%	6.60%	15%	10%	6.00%
Above​ $80 million	23%	15%	9.00%	24%	16%	9.60%

Lowest costs
Up to​ $40 million of new capital	Domestic equity + European debt	=0.5*12%+0.5*3%	7.50%
​ $41 million to​ $80 million of new capital	European equity + European debt	=0.5*15%+0.5*6%	10.50%
Above​ $80 million	Domestic equity + Domestic debt	=0.5*23%+0.5*9%	16.00%

Assume that the debt to equity ratio of 1:1 needs to maintained for the new capital fo $60M. Up to $40M, European debt+ US equity is the cheapest. From $41M to $60M, European debt and European equity is the cheapest. Hence, cost structure is as below

Funding source	Value ($M)	Cost
European Debt	20	3%
US Equity	20	12%
European Debt	10	6%
European Equity	10	15%
Total	60	8.50%