Question

Olsen Outfitters Inc. believes that its optimal capital structure consists of 40% common equity and 60% 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 = 14%. New common stock in an amount up to $10 million would have a cost of re = 16%. Furthermore, Olsen can raise up to $4 million of debt at an interest rate of rd = 11% and an additional $6 million of debt at rd = 13%. The CFO estimates that a proposed expansion would require an investment of $6.3 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Answer 1

The firm needs to raise $6.3 million. The firm should first use the lowest cost way of raising capital, and then consider the next lowest cost alternative, and so on.

The after tax cost of the first $4 million of debts is 11%*(1 - 40%) = 6.6%.

For the next $2.3 million, the after-tax cost is 13%*(1 - 40%) = 7.8%.

Both costs are lower than the cost of equities. So it is optimal for the firm to raise the required fund first using debts.

Therefore, the firm should first borrow $4 million at a cost of 6.6%, and then the remaining $2.3 million at the cost of 7.8%. The cost of raising the last dollar is the after-tax cost of debt, which is 7.8%.