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 rs = 12%. New common stock in an amount up to $7 million would have a cost of re = 16%. Furthermore, Olsen can raise up to $2 million of debt at an interest rate of rd = 10%, and an additional $5 million of debt at rd = 12%. The CFO estimates that a proposed expansion would require an investment of $5.7 million.
Required:
What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Answer 1

Answer: 12.5%

Explanation:

Amount that will be raised with Equity = 65% * 5,700,000 = $3,705,000

This is more than the retained earnings so new equity will have to be issued at cost of 16%

Amount raised by debt = 35% * 5,700,000 = $1,995,000

Less than $2 million so cost of debt is 10%

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

= (16% * 65% ) + (35% * 10% * (1 - 40% tax))

= 12.5%