Question

Olsen Outfitters Inc. believes that its optimal capital structure consists of 40% common equity and 60% debt, and its tax rate is 25%. 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 = 12%. New common stock in an amount up to $7 million would have a cost of r_e = 13.5%. Furthermore, Olsen can raise up to $4 million of debt at an interest rate of r_d = 10% and an additional $6 million of debt at r_d = 13%. The CFO estimates that a proposed expansion would require an investment of $3.8 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

%

Answer 1

Investment Amount required = $ 3800000

Given Optimal Capital structure is 40% Common Equity and 60% Debt

So total equity needed for new investment = $ 3800000*0.40

= $1520000

Since we are already having $ 10,00000 retained earnings so additional shares should be issued for an amount of $ 520000

Cost of Equity for raising $ 520000 = 13.5%

Amount of Debt required for new investment = $ 3800000*0.60

= $ 2280000

Hence we require only $ 2.28 Million of Debt.

Cost of Debt for raising $ 2.28 Million = 10% ( Since the debt is lower than $ 4 Million , so 10% rate is applicable)

Given Tax rate = 25%

Computation of After tax cost of Debt

After Tax cost of Debt = 10% ( 1-Tax rate)

= 10% ( 1-0.25)

= 7.5%

Computation of Weighted Average Cost of Capital

Particulars	Amount	Weight	After tax cost of Capital( %)	WACC( Weight * After tax cost of Capital) in %
Retained Earning	$1,000,000	$ 10,00000/$ 3800000 = 0.2632	12	12*0.2632=3.1584
Equity	$520,000	$ 520000/$ 3800000 = 0.1368	13.5	13.5*0.136=1.836
Debt	$2,280,000	$ 2280000/$ 3800000 = 0.6	7.5	7.5*0.6= 4.5
Total	$3,800,000			9.51

* WACC = Weight of Retained earnings * Cost of Retained earning+ Weight of Equity * Cost of Equity + Weight of Debt * After tax Cost of Debt.

Hence WACC is 9.51%

If you are having any doubts, please post a comment.

Thank you. Please rate it.