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 $1 million of retained earnings with a cost of rs = 12%. New common stock in an amount up to $6 million would have a cost of re = 16%. Furthermore, Olsen can raise up to $3 million of debt at an interest rate of rd = 11% and an additional $4 million of debt at rd = 12%. The CFO estimates that a proposed expansion would require an investment of $6.4 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Answer 1

As we know,

WACC = x Re + x Rd x (1 – Tc)

Where:

• Re = cost of equity
• Rd = cost of debt
• E = market value of the firm’s equity
• D = market value of the firm’s debt
• V = E + D
• E/V = percentage of financing that is equity
• D/V = percentage of financing that is debt
• Tc = corporate tax rate

now,

As per given question,

Olsen Outfitters Inc has capital structure of 70% common equity and 30% debt, and its tax rate is 40%.

Retained earning $1 million at cost of 12%
Common stock is $ 6 million at cost of 16%
Debt investment $ 3 million at cost of 11%
Additional Debt $ 4 million at cost of 12%

As per CEO proposed expansion would required $6.4 million wherein they already have $1million retained earning hence they need to raise money $5.4 with proportion of 70:30

It means company will raise $3.78 million equity @ 16 % and $1.62 million debt @11%

Now

WACC for this portfolio will be as per above formula

3.78/6.4*16+ 1/6.4*12+ 1.62/6.4*11(1-0.4)

9.45+ 1.87+2.78(0.6)

14.10*0.6

WACC = 8.46 %