Question

Olsen Outfitters Inc. believes that its optimal capital structure consists of 35% common equity and 65% 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 $10 million would have a cost of r_e = 13.0%. Furthermore, Olsen can raise up to $4 million of debt at an interest rate of r_d = 11% and an additional $3 million of debt at r_d = 12%. The CFO estimates that a proposed expansion would require an investment of $6.0 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

______%

Answer 1

Equity portion = 35%

Equity amount of proposed expansion = $ 6 million*35%

= $ 2.1 million

Company can raise $ 1 million of proposed expansion from retained earning which have a cost of 12%

But since we want to raise $ 2.1 million we will raise it through new common stock having cost of 13%

Cost of Equity = 13.5%

- Debt Portion = 65%

Debt amount of proposed expansion = $ 6 million*65%

= $ 3.90 million

Company can raise upto $ 4 million of debt with interest rate of 11%. Thus, $ 3.90 of proposed amount of debt will have a cost of 11%

So, Before-tax cost of debt= 11%

Calculating WACC:-

WACC= (Weight of Debt)(Before-tax Cost of Debt)(1-Tax Rate) + (Weight of Equity)(Cost of Equity)

WACC = (0.65)(11%)(1-0.25) + (0.35)(13%)

WACC = 5.3625% + 4.45%

WACC = 9.91%

So, the WACC for the last dollar raised to complete the expansion is 9.91%

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