Question

lsen Outfitters Inc. believes that its optimal capital structure consists of 45% common equity and 55% 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 $2 million of debt at an interest rate of rd = 9% and an additional $4 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

Amount funded by equity = %age of equity*investment = 3.2*0.45 = 1.44

As retained earning is only 1 m, new common stock has to be raised at 13%

Amount neede for debt = 3.2-1.44 = 1.76m

Debt can be raised at 9%

Weight of equity = 1-D/A

Weight of equity = 1-0,55

W(E)=0,45

Weight of debt = D/A

Weight of debt = 0,55

W(D)=0,55

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*0,55+13*0,45

WACC =9,56%