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 $3 million of retained earnings with a cost of rs = 14%. New common stock in an amount up to $8 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 = 14%. The CFO estimates that a proposed expansion would require an investment of $11.8 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Answer 1

Total Investment Needed = $11.8 million

Equity Investment = 0.7 x $11.8 million = $8.26 million

Out of the equity part of the investment $3 million can be raised from the retained earnings

Rest of the investment's equity part can be raised by the issue of new equity @ 16%

Debt Investment = 0.3 x $11.8 million = $3.54 million

Debt Investment can be made from First Debt Issue @ 11%

So,

WACC = [wD x kD x (1 - t)] + [wS x rS] + [wE x rE]

= [0.3 x 11% x (1 - 0.40)] + [(3/8.26) x 14%] + [(5.26/8.26) x 16%]

= 1.98% + 5.08% + 10.19% = 17.25%