Question

Olsen Outfitters Inc. believes that its optimal capital structure consists of 70% common equity and 30% 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 rs = 12%. New common stock in an amount up to $6 million would have a cost of re = 13.0%. Furthermore, Olsen can raise up to $3 million of debt at an interest rate of rd = 10% and an additional $5 million of debt at rd = 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

Cost of Retained earnings upto $1 million( rs ) = 12%.

Cost of common equity up to $6 million  (re) = 13.%.

Before tax cost of debt up to $3 million (rd) = 10%

Before-tax cost of debt up to $8 million  rd = 12%.

Cost of Investment/project = $6.0 million

Tax rate =25%

Capital Structure : 70% equity and 30% debt

WACC= W_d r_d ( 1- T) + Were   

where WACC = Weighted avg Cost of capital

    Wd =Weight of debt

  We= Weight of equity

  r_d =Cost of debt

re = Cost of equity

T = tax rate

1) Debt -30%

Amount of Debt = Investmnet * 30%

=$6,000,000 * 30%

=$1,800,000

Since the amount of Debt is less than $3 millions, the Cost of debt (rd) =10%

2)Equity -70%

Amount of equity = 70% of investment

=$6,000,000 * 70%

Amount of equity =$4,200,000

Here since the equity amount exceeds retained earnings , the Cost of Equity (re) = 13%

Computation of WACC:

WACC= W_d r_d ( 1- T) + Were   

=30%(10%) [1-25%] + 70%(13%)

=0.3*0.1*0.75 + 0.7*.0.13

=2.25% + 9.1%

WACC = 11.35%