Question

Olsen Outfitters Inc. believes that its optimal capital structure consists of 60% common equity and 40% 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 r_s = 12%. New common stock in an amount up to $9 million would have a cost of r_e = 15.0%. Furthermore, Olsen can raise up to $4 million of debt at an interest rate of r_d = 11% and an additional $5 million of debt at r_d = 15%. The CFO estimates that a proposed expansion would require an investment of $8.2 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Answer 1

	Given,
	Optimal Capital Structure, Where
	Commom Equity = 60%
	Debt = 40%
	Retained Earnings with the Firm = $3000000
	Cost of Retained Earnings = rs = 12%
	New Common Stock = $9000000
	Cost of New Common Stock = re = 15%
	Debt = $4000000
	Cost of Debt = rd = 11%
	Additional Debt = $5000000
	Cost of additional debt = 15%
	Proposed Expansion = $8200000
	Now, Please note following things.
1	Debt is the cheapest source of finance as it has a tax advantage benefit.
2	Out of Retained Earnings and New Common Stock, Retained Earnings
	should be preferable and it is economical too as new common stock
	coming with the flotation costs.
	Takig into consideration the above points, the proposed expansion
	should be funded as follows
a)	Value of Debt in Propsed Expansion
	= Proposed Expansion * % of Debt in Optimal Capital Structure
	= $8200000 * 40%
	= $3280000
	Cost of this debt is 11%, as maxmium debt can be raised of $4000000 @ 11%
	Weight of Debt in Proposed Expansion = Value of Debt / Proposed Expansion
					= $3280000 / $8200000
					= 0.40
b)	After Debt, Retained Earnings should be utilised for expansion.
	So, Maximum Retained Earnings are $3000000 @ 12%
	Value of Retained Earnings in Proposed Expansion = $3000000
	Cost of Retained Earnings = 12%
	Weight of Retained Earnings in Proposed Expansion = Value of Retained Earnings / Proposed Expansion
						= $3000000 / $8200000
						= 0.36585
c)	Balanced Propsed Expansion should be utilised by using New Common Stock
	Value of New Common Stock in Proposed Exapansion
	= Proposed Expansion - Value of Debt - Value of Retained Earnings
	= $8200000 - $3280000 - $3000000
	= $1920000
	Cost of New Common Stock = 15%
	Weight of New Common Stock in Proposed Expansion = Value of New Common Stock / Proposed Expansion
						= $1920000 / $8200000
						= 0.23415
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