Question

Olsen Outfitters Inc. believes that its optimal capital structure consists of 65% common equity and 35% debt, and its tax rate is 40%. Olsen must raise additional capital to fund its upcoming expansion. The firm will have $2 million of retained earnings with a cost of rs = 13%. New common stock in an amount up to $9 million would have a cost of re = 17%. Furthermore, Olsen can raise up to $2 million of debt at an interest rate of rd = 9% and an additional $6 million of debt at rd = 12%. The CFO estimates that a proposed expansion would require an investment of $3.2 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Answer 1

The $3.2 million expansion should be funded in the following proportions:
Equity financing = $3.2 million × 0.65 =	$2,080,000.00
Debt financing = $3.2 million × 0.35	$1,120,000.00
Equity financing components to total $$2,080,000	Market Value	Weights	Cost	WACC= Weights X cost
Retained Earnings (Given) = $2,000,000/$3,200,000	$2,000,000.00	62.50%	13.00%	8.13%
Common Stock = ($2,080,000 - $2000000)/$3,200,000	$80,000.00	2.50%	17.00%	0.43%
Debt	$1,120,000.00	35.00%	5.40%	1.89%
Total	$3,200,000.00	100.00%		10.44%
Cost of debt after tax = 9% x (1-40%) = 5.40%
Average overall WACC	10.44%
The WACC for the last dollar of the expansion involves issuing	Weights	Cost	WACC= Weights X cost
New Common Stock (62.50% + 2.50%)	65.00%	17.00%	11.05%
New Debt	35.00%	5.40%	1.89%
Total	100.00%		12.94%