Question

WACC 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 $5 million of retained earnings with a cost of r's = 15%. New common stock in an amount up to $7 million would have a cost of re = 19%. Furthermore, Olsen can raise up to $3 million of debt at an interest rate of ra = 11% and an additional $3 million of debt at rd = 13%. The CFO estimates that a proposed expansion would require an investment of $7.8 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Answer 1

Equity Financing Needed for Expansion = Investment * wE = $7.8 million * 0.70 = $5.46 million

First $5 million will be financed by retained earnings and the last $0.46 million will be financed by new common stock. So, kE for last dollar raised is 19%.

Debt Financing Needed for Expansion = Investment * wD = $7.8 million * 0.30 = $2.34 million

So, all of debt financing can be raised at the kD of 11%

So, WACC for last dollar raised = [wD * kD * (1 - t)] + [wE * kE]

= [0.3 * 11% * (1 - 0.40)] + [0.7 * 19%]

= 1.98% + 13.3% = 15.28%