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 r_s= 15%. New common stock in an amount up to $6 million would have a cost of r_e = 17%. Furthermore, Olsen can raise up to $3 million of debt at an interest rate of r_d = 10% and an additional $4 million of debt at r_d = 11%. The CFO estimates that a proposed expansion would require an investment of $4.3 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

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Answer 1

firm needs = $4.3 million.

The firm should first utilise the lowest cost of raising capital.

The after tax cost of the first 3  million of debts = 10%*(1 - 40%) = 6%.

For the next 4  million, the after-tax cost is = 11%*(1 - 40%) = 6.6%. Both costs are less than the cost of equities.

.the firm should first borrow 3 million at a cost of 6%,

remaining 1.3 million at the cost of 6.6%.

The cost of raising the last dollar is the after-tax cost of debt, which is 6.6%.