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 $5 million of retained earnings with a cost of rs = 15%. New common stock in an amount up to $7 million would have a cost of re = 19%. Furthermore, Olsen can raise up to $3 million of debt at an interest rate of rd = 11% and an additional $3 million of debt at rd = 13%. The CFO estimates that a proposed expansion would require an investment of $7.8 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Answer 1

If the investment requires $7.80 million, that means that it requires $5.46 million (70%) of common
equity and $2.34 million (30%) of debt. In this scenario, the firm would exhaust its $5 million of retained
earnings and be forced to raise new stock at a cost of 19%. Needing $2.34 million in debt, the firm could
get by raising debt at only 11%. Therefore, its weighted average cost of capital is:
WACC = 0.30(11%)(1 - 0.4) + 5/7.8 x 15% + 0.46/7.8 x 19% = 12.72%.