Question

Olsen Outfitters Inc. believes that its optimal capital structure consists of 65% common equity and 35% 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 r_s = 13%. New common stock in an amount up to $6 million would have a cost of r_e = 14.5%. Furthermore, Olsen can raise up to $4 million of debt at an interest rate of r_d = 10% and an additional $3 million of debt at r_d = 13%. The CFO estimates that a proposed expansion would require an investment of $6.5 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Answer 1

The WACC is computed as follows:

Amount of Equity is computed as follows:

= 65% x $ 6.5 million

= $ 4.225 million (Since it is above $ 2 million and below $ 6 million, hence cost will be 14.5%)

Amount of Debt will be as follows:

= 35% x $ 6.5 million

= $ 2.275 million (Since it is up to $ 4 million, hence cost will be 10%)

Hence WACC will be as follows:

= cost of equity x weight of equity + cost of debt x (1 - tax rate) x weight of debt

= 0.145 x 0.65 + 0.10 x (1 - 0.40) x 0.35

= 0.09425 + 0.021

= 11.53%

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