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 r_s = 10%. New common stock in an amount up to $8 million would have a cost of r_e = 12.0%. Furthermore, Olsen can raise up to $4 million of debt at an interest rate of r_d = 10% and an additional $4 million of debt at r_d = 14%. The CFO estimates that a proposed expansion would require an investment of $8.0 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Answer 1

equity = 70% of amount to raise = 0.7*8 =5.6mn  
  
debt = 30% of capital to raise =0.3*8 = 2.4mn  
  
company will have to raise equity as retained earnings of 1m is not sufficient  
  
company can raise debt in 1st tranche as 4mn limit for debt tranche 1 is sufficient  
  
After tax cost of debt = cost of debt*(1-tax rate)  
After tax cost of debt = 9*(1-0.25)  
6.75  
WACC=after tax cost of debt*W(D)+cost of equity*W(E)  
WACC=6.75*0.3+12*0.7  
=2.03+8.4
WACC =10.43%