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 $5 million of retained earnings with a cost of rs = 15%. New common stock in an amount up to $7 million would have a cost of re = 19%. Furthermore, Olsen can raise up to $3 million of debt at an interest rate of rd = 11% and an additional $3 million of debt at rd = 13%. The CFO estimates that a proposed expansion would require an investment of $7.8 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Answer 1

The weighted average cost of capital (WACC) is the cost of raising capital, with the weights representing the proportion of each source of financing that is used.

WACC = wd * rd (1 - t) + ws*rs   + we * re            

Where,

Total required investment = $7.8 million

Optimal capital structure of Olsen Outfitters Inc. consists of 70% common equity and 30% debt

Therefore,

Total equity = 70% * $7.8 million = $ 5.46 million

The firm will have $5 million of retained earnings with a cost of rs = 15%. New common stock in an amount up to $7 million would have a cost of re = 19%

Therefore

rs is the cost of equity =15% for $5 million

And cost of equity re = 19% for additional $0.46 million

And Total debt = 30% * $7.8 million = $2.34 million

Olsen can raise up to $3 million of debt at an interest rate of rd = 11%; therefore cost of debt = 11%

Tax rate t = 40%

wd is the weight of debt = 30%

ws is the weight of stock (retained earnings)= $5/ $7.8 = 64.10%

we is the weight of equity =$0.46/ $7.8 = 5.90%

Therefore,         

WACC = 30% * 11% * (1-40%) + 64.10% *15% + 5.90% * 19%

= 1.98% +9.62% + 1.12%

= 12.72%

Weighted average Cost of capital is 12.72%