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 $1 million of retained earnings with a cost of r_s = 13%. New common stock in an amount up to $9 million would have a cost of r_e = 16%. Furthermore, Olsen can raise up to $3 million of debt at an interest rate of r_d = 10% and an additional $5 million of debt at r_d = 13%. The CFO estimates that a proposed expansion would require an investment of $9.0 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Answer 1

Given-

Cost of retained earnings up to $1 million (r_s ) = 13%

Cost of common equity up to $9 million (r_e ) = 16%

Before tax cost of debt up to $3 million (r_d ) = 10%

Before tax cost of debt up to $5 million (r_d ) = 13%

Dollar Cost of Investment/Project = $9000000

Tax rate = 40%

Target Capital Structure = 70% common equity and 30% debt

Required WACC

Formula-

WACC = w_dr_d(1-T) + w_er_e

Where, WACC= weighted average cost of capital

w_d = weight of debt

w_e = weight of common equity

r_d = cost of debt

r_e = cost of common equity/retained earnings

T = Tax rate

1. Debt - 30% of $9.0 million investment

Amount of Debt = 0.30 * 9000000 = $2700000

The cost of debt r_d will be 10% since it is less than $3 million.

2. Equity - 70% of $9.0 mllion investment

Amount of Equity = 0.70 * 9000000 = $6300000

The cost of equity r_e will be 16%

3. WACC =  w_dr_d(1-T) + w_er_e

=30%*10% (1-40%) + 70%*16%

=0.30*0.10 (1-0.40) + 0.70*0.16

=0.13

Answer =13%