Question

Olsen Outfitters Inc. believes that its optimal capital structure consists of 65% common equity and 35% debt, and its tax rate is 25%. Olsen must raise additional capital to fund its upcoming expansion. The firm will have $3 million of retained earnings with a cost of rs = 13%. New common stock in an amount up to $7 million would have a cost of re - 14.5%. Furthermore, Olsen can raise up to $4 million of debt at an interest rate of ro - 11% and an additional $4 million of debt at ro - 12%. The CFO estimates that a proposed expansion would require an investment of $4.8 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 required = $ 4.8 million

Equity required = 65% of $ 4.8 million = $ 3.12 million

Debt required = 35% of $ 4.8 million = $ 1.68 million

Assuming, company will fund the investment in the desired debt equity ratio.

Cost of equity

First $ 3 million will be met from retained earnings as its cost of capital (13%) is lower than fresh equity (14.5%). Balance $ 0.12 million equity will be raised fresh at 14.5% cost of equity. So weighted average cost of equity is 13.06%.

Cost of debt

$ 1.68 million debt required will be fully met through the lower cost tranche of $ 4 million at 11%. Hence cost of debt is 11%.

WACC for the project

WACC = ((Costof equity* Amountofequity)+(Costof debt* Amountof debt* (1 – taxrate)))/(Amounto fequity + Amountof debt)

Hence:

WACC = (13.06%*3.12 + 11%*1.68*(1-25%)) / (3.12+1.68) = 11.38%