Question

Olsen Outfitters Inc. believes that its optimal capital structure consists of 70% common equity and 30% debt, and its tax rate is 40%. 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 $10 million would have a cost of re = 14%. Furthermore, Olsen can raise up to $2 million of debt at an interest rate of rd = 10% and an additional $6 million of debt at rd = 11%. The CFO estimates that a proposed expansion would require an investment of $5.4 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

%

Answer 1

Total Investment = $5,400,000

Weight of debt = 30%

Weight of equity = 70%

Value of debt = $5,400,000 × 30%

= $1,620,000

Value of debt is $1,620,000.

Value of equity = $5,400,000 - $1,620,000

= $3,780,000

Value of equity is $3,780,000.

Company can raise Debt upto 2 million at 10%.

So, Value of retained earning = $1,000,000

Value of external equity = $2,780,000

Value of debt = $1,620,000.

Weight of debt = 30%

Weight of retained earning = 18.52%

Weight of external equity = 51.48%

Now, WACC is calculated below:

WACC = (18.52% × 12%) + (51.48% × 14%) + (30% × 10%) × (1 - 40%)

= 2.22% + 7.21% + 1.80%

= 11.23%

WACC of company is 11.23%.