Question

1. Olsen Outfitters Inc. believes that its optimal capital structure consists of 55% common equity and 45% debt, and its tax rate is 40%. Olsen must raise additional capital to funds its upcoming expansion. The firm will have $4 million of retained earnings with a cost of r_s = 11%. New common stock in an amount up to $8 million would have a cost of r_e = 12.5%. Furthermore, Olsen can raise up to $4 million of debt at an interest rate of r_d = 9% and an additional $5 million of debt at r_d = 13%.
   1. The CFO estimates that a proposed expansion would require an investment of $7.0 million. What is the WACC for the last dollar raised to complete the expansion?
   2. If the firm needs to raise $8.2 million for its upcoming expansion, what is the WACC for the last dollar raised to complete the expansion?
   3. If the firm needs to raise $10.5 million for its upcoming expansion, what is the WACC for the last dollar raised to complete the expansion?

Answer 1

Olsen Outfillters
Available funds for investment
Tax rate =	40%

Capital Type	Available Capital	Cost=r	After Tax Cost =r*(1-T)
Retained earning	$         4,000,000	11.00%	11.00%
New Common Stock	$         8,000,000	12.50%	12.50%
Debt 1	$         4,000,000	9.00%	5.40%
Debt 2	$         5,000,000	13.00%	7.80%

Desired Debt : Equity =45% : 55%
Ans a.
Required Fund 7 Million
Required Debt =7M*45% =	$   3,150,000.00
Required Equity =7M*55%=	$   3,850,000.00
WACC Calculation with the required Fund Source
Capital Type	Fund Value	Weight of Fund	After Tax cost	Weighted cost
Retained earning	$   3,850,000.00	55%	11.00%	6.05%
Debt 1	$   3,150,000.00	45%	5.40%	2.43%
Total	$   7,000,000.00	100%		8.48%
So WACC for this Capital =8.48%

Ans b.
Required Fund =	$         8,200,000
Required Debt @45% =	$   3,690,000.00
Required Equity =55%=	$   4,510,000.00

WACC Calculation with the required Fund Source
Capital Type	Fund Value	Weight of Fund	After Tax cost	Weighted cost
Retained earning	$   4,000,000.00	49%	11.00%	5.37%
New Common Stock	$       510,000.00	6%	12.50%	0.78%
Debt 1	$   3,690,000.00	45%	5.40%	2.43%
Total	$   8,200,000.00	117%		8.57%

So WACC for this Capital =8.57%

Ans c.
Required Fund =	$       10,500,000
Required Debt @45% =	$   4,725,000.00
Required Equity =55%=	$   5,775,000.00

WACC Calculation with the required Fund Source
Capital Type	Fund Value	Weight of Fund	After Tax cost	Weighted cost
Retained earning	$   4,000,000.00	38%	11.00%	4.19%
New Common Stock	$   1,775,000.00	17%	12.50%	2.11%
Debt 1	$   4,000,000.00	38%	5.40%	2.06%
Debt 2	$       725,000.00	7%	7.80%	0.54%
Total	$ 10,500,000.00	100%		8.90%
So WACC for this Capital =8.90%