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 $5 million of retained earnings with a cost of r_s = 11%. New common stock in an amount up to $8 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 = 9% and an additional $5 million of debt at r_d = 13%. The CFO estimates that a proposed expansion would require an investment of $8.6 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Answer 1

*Any doubt please comment

WACC = 9.96%

Workings:

	Amount	weights	Cost of capital	WACC
Debt	2580000	0.30	6.75%	2.025%
Equity	1,020,000	0.12	13.00%	1.542%
Retained earnings	5,000,000	0.58	11.00%	6.395%
Total	8,600,000			9.96%

Amount of debt invested = 30% * 8,600,000 = 2,580,000

Amount of equity = 70% * 8,600,000 = 6,020,000

Cost of debt = 9% * (1-25%) = 6.75%

Cost of equity = 13%