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 $10 million would have a cost of r_e = 19%. Furthermore, Olsen can raise up to $4 million of debt at an interest rate of r_d = 11% and an additional $4 million of debt at r_d = 12%. The CFO estimates that a proposed expansion would require an investment of $8.6 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Answer 1

Final answer

WACC = 14.81 %

Explanation

Total Investment = 8.60 million. Sources of financing this Investment comprises of 30% Debt = 8.6 * 0.30 = 2.58 million.

This debt amount is lower than 4 million, hence cost of debt = 11%. After tax rd = 11*(1-0.40) = 6.60 %

Retained earnings will be used = 1 million. Thus new common stock = 8.60 * 0.70 - 1 million = 5.02 millions and cost of equity (re) = 19%

Calculation of WACC

	Amount	Weight	K	K*W
Common stock	5.02	0.583721	19	11.0907
Retained earnings	1	0.116279	15	1.7442
Debt	2.58	0.3	6.6	1.98
	8.6		WACC	14.81