Question

1.

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 $4 million of retained earnings with a cost of r_s = 14%. New common stock in an amount up to $9 million would have a cost of r_e = 18%. Furthermore, Olsen can raise up to $4 million of debt at an interest rate of r_d = 9% and an additional $6 million of debt at r_d = 10%. The CFO estimates that a proposed expansion would require an investment of $11.4 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

2.

Hook Industries's capital structure consists solely of debt and common equity. It can issue debt at r_d = 8%, and its common stock currently pays a $2.75 dividend per share (D₀ = $2.75). The stock's price is currently $31.75, its dividend is expected to grow at a constant rate of 9% per year, its tax rate is 40%, and its WACC is 13.35%. What percentage of the company's capital structure consists of debt? Do not round intermediate calculations. Round your answer to two decimal places.

3.

Empire Electric Company (EEC) uses only debt and common equity. It can borrow unlimited amounts at an interest rate of r_d = 10% as long as it finances at its target capital structure, which calls for 35% debt and 65% common equity. Its last dividend (D₀) was $2.55, its expected constant growth rate is 3%, and its common stock sells for $22. EEC's tax rate is 40%. Two projects are available: Project A has a rate of return of 15%, and Project B's return is 9%. These two projects are equally risky and about as risky as the firm's existing assets.

1. What is its cost of common equity? Round your answer to two decimal places. Do not round your intermediate calculations.
   %
2. 
   
3. What is the WACC? Round your answer to two decimal places. Do not round your intermediate calculations.
   %
4. 
   
5. Which projects should Empire accept?

Answer 1

1)

Market value Cost % Weight 0.7000 WACC (Cost %*Weights) 12.60% Cost of equity 18.00% $ 70.00 Debt (After tax cost) $ 30.00 0.3000 1.62% 5.40% =9%*(1-40%) Total $ 100.00 | 1.0000 Weighted average cost of capital (WACC) 14.22%

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