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 = 12%. New common stock in an amount up to $7 million would have a cost of re = 14%. Furthermore, Olsen can raise up to $2 million of debt at an interest rate of rd = 10% and an additional $4 million of debt at rd = 11%. 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

Answer:

The WACC for the last dollar raised is 10.68%

Explanation:

Hi, first we have to determine how much is going to come from debt and how much would have to come from equity in order to preserve the current capital structure (70% equity, 30% debt), so we need to multiply each percentage by the total amount of the investment, therefore obtaining the amount of money that would have to come from equity and debt, that is as follows.

$Debt(dollars)=0.3*6.5=1.95\\\\Equity(dollars)=0.7*6.5=4.55$

Ok, now, common sense tells us that we need to pick the cheaper sources of debt and equity, therefore, for the $1.95 millions in debt, we would have to use the $2 millions in debt at a rd=10% (just 1.95).

We also require to know how much in equity we need, therefore, we have to discount from the least expensive to the most expensive, therefore.

Equity(retained earnings) = $3 millions (this is at re=12%)

Equity(Common Stock) = $1.55 millions (this is at re =14%)

Now, all the money we obtain from debt is tax deductable, but the money from equity is not, therefore we need to use the following equation.

$WACC=CostDebt(\frac{Debt}{Debt+Equity} )(1-Taxes)+CostEquity(\frac{Equity}{Debt+Equity)}$

Everything should look like this

$WACC=0.10(\frac{1.95}{1.95+4.55} )(1-0.4)+0.12(\frac{3}{1.95+4.55)} +0.14(\frac{1.55}{1.95+4.55)}$

$WACC=0.018+0.05538+0.03338=0.1068$

So the WACC for the last dollar raised to complete the expansion would be 10.68%

Best of luck.