Question

OO 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 = 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 = 10% and an additional $4 million of debt at r_d = 14%. The CFO estimates that a proposed expansion would require an investment of $11.0 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Answer 1

The funds required are $11 million

If target Equity:Debt proportion of 70:30 is to be followed

Amount of Debt to be taken = 30% of $11 million = $3.3 million which can be raised at 10%

Amount of equity can be comprised of retained earnings and additional new common stock

Retained earnings of $1 million is available at 11%

and remaining new common stock required = $11 million -$3.3 million -$1 million = $6.7 million

which can be raised at 13%

So, WACC = weight of debt/Total capital* cost of debt*(1-tax rate) + weight of retained earnings*cost of retained earnings+ weight of new common stock*cost of new common stock

= 3.3/11*10%*(1-0.25) + 1/11*11%+ 6.7/11*13%

=11.1682% or 11.17%