Question

# Olsen Outfitters Inc. believes that its optimal capital structure consists of 70% common equity and 30%...

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 rs = 15%. New common stock in an amount up to \$10 million would have a cost of re = 19%. Furthermore, Olsen can raise up to \$4 million of debt at an interest rate of rd = 11% and an additional \$4 million of debt at rd = 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.

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

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