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 $3 million of retained earnings with a cost of rs = 12%. New common stock in an amount up to $10 million would have a cost of re = 16%. Furthermore, Olsen can raise up to $4 million of debt at an interest rate of rd = 11% and an additional $6 million of debt at rd = 12%. The CFO estimates that a proposed expansion would require an investment of $4.7 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Answer 1

First we need to figure out which sources will be used to raise the invesment amount required of 4.7million. We have three options , retained earnings, new common stock and debt. Since retained earnings is only 3mn, its not enough and we need an additional source.

Now comparing the cost of various funding sources, we come to the conclusion that it will be prudent to raise maximum amount from the cheapest source.

so, we out of 4.7mn of investment required, we plan to borrow 4mn from debt as it has the lowest rate of 11%.

Then, we can either go for additional debt or retained earnings of 0.7mn, both available at 12%. Notice, we won't go for new common stock as it is the most expensive at 16%.

we prefer additional debt over retained earnings as debt also provides a tax-shield since interest expenses are tax-deductible. The after-tax cost of debt becomes the chepaest.

WACC = [ (debt1 / total debt)* after-tax cost of debt1 ] + [(debt2/ total debt)* after-tax cost of debt2]

= [ 4/4.7 * (11% * (1-0.4) ) ] + [ 0.7/4.7 * (12% * (1-0.4) ) ]

= 6.69%

Note: On a pre-tax basis,

WACC = [ 4/4.7 * 11% ] + [ 0.7/4.7 * 12% ] = 11.15%

But WACC should always be calculated on an after-tax basis since it gives the more real picture.