Question

Question 4 Unsaved Klose Outfitters Inc. believes that its optimal capital structure consists of 60% common equity and 40% debt, and its tax rate is 40%. Klose must raise additional capital to fund its upcoming expansion. The firm will have $2 million of new retained earnings with a cost of rs=10.78%. New common stock in an amount up to $6 million would have a cost of re=14.99%. Furthermore, Klose can raise up to $3 million of debt at an interest rate of rd=10% and an additional $4 million of debt at rd=12%. The CFO estimates that a proposed expansion would require an investment of $5.9 million. What is the WACC for the last dollar raised to complete the expansion?

Answer 1

Debt Equity ratio 40% & 60% respectively
Fund required =$5.9 Million
$5.9 Million will be financed through debt=5.9*40%=2.36 Million with cost before tax 10%
$5.9 Million will be financed through equity=5.9*60%=3.54 Million
Out of 3.54 million it will be financed through retained earning = $2 Million with cost 10.78% & 1.54 Million through issue of equity with cost 14.99%
Tax rate =40%
Now the question is asking WACC of last dollar raised, so we will not consider 2 Million retained earning financed with cost of capital 10.78% for the purpose of calculation of WACC
So WACC will be
WACC=Wd*rd*(1-t)+We*re
=.40*10%*(1-.40)+.6*14.99%			11.39%