Question

WACC Olsen Outfitters Inc. believes that its optimal capital structure consists of 55% common equity and 45% debt, and its tax rate is 40%. Olsen must raise additional capital to fund its upcoming expansion. The firm will have $2 million of retained earnings with a cost of rs = 15%. New common stock in an amount up to $9 million would have a cost of re = 19%. Furthermore, Olsen can raise up to $4 million of debt at an interest rate of rd = 9% and an additional $5 million of debt at rd = 12%. The CFO estimates that a proposed expansion would require an investment of $6.0 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Answer 1

Project cost = $6 million

We need to allocate equity and debt in proportion of 55% and 45% respectively.

Debt should consist of 45% that will sum up to = $6 x 45% = $2.7 million which can be raised at 9% cost.

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Balance $3.3 million (6-2.7) should come from retained earnings and new equity, we have $ 2 million in cost of retained earnings and then balance of $1.3 million will come from new equity.

rs = 15% ; re = 19%; rd = 9% and tax rate = 40%

Weight of debt = wrd = 2.7/6 ; Weight of retained earning = wrs = 2/6 ; weight of new equity = wre = 1.3/6

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WACC = rs x wrs + re x wre + rd x wrd x (1-tax rate)

WACC = 15% x 2/6 + 19% x 1.3/6 + 9% x 2.7/6 x (1-40%)

WACC = 11.55%