Question

Olsen Outfitters Inc. believes that its optimal capital structure consists of 70% common equity and 30% debt, and its tax rate is 40%. Olsen must raise additional capital to fund its upcoming expansion. The firm will have $4 million of retained earnings with a cost of r_s = 10%. New common stock in an amount up to $7 million would have a cost of r_e = 11.5%. Furthermore, Olsen can raise up to $3 million of debt at an interest rate of r_d = 11% and an additional $6 million of debt at r_d = 14%. The CFO estimates that a proposed expansion would require an investment of $7.9 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

  %

Answer 1

Answer : Calculation of WACC

WACC = (Cost of After tax Debt * Weight of Debt) + ( Cost of Equity * Weight of Equity)

To determine the cost of equity we need to calculate the amount to be raised from different sources .

Amount that can be raised through debt = 7.9 million * 30% = 2.37 million

Given Olsen can raise up to $3 million of debt at an interest rate of r_d = 11% therefore before tax cost of debt will be 11%

Amount that can be raised through Equity = 7.9 million * 70% = 5.53 million

The amount that can be raised through retained earning is 4 million at a cost of 10%

Remaining 1.53 million (5.53 - 4 ) will be raised through issue of new common stock at cost of 11.5%

Weights are Calculated as = Respective Value / Total Value

WACC = (Cost of After tax Debt * Weight of Debt) + ( Cost of Retained Earning * Weight of Retained Earning) + ( Cost of Equity * Weight of Equity)

= [11% * (1 - 0.40) * (2.37 / 7.9)] + [10% * (4 / 7.9)] + [11.5% * (1.53 / 7.9)]

= 1.98% + 5.06% + 2.23%

= 9.27%