Klose Outfitters Inc. believes that its optimal capital structure consists of 70

Question

Klose Outfitters Inc. believes that its optimal capital structure consists of 70% common equity and 30% debt, and its tax rate is 40%. Klose must raise additional capital to fund its upcoming expansion. The firm will have $1 million of retained earnings with a cost of rs = 14%. New common stock in an amount up to $9 million would have a cost of re = 18%.  Furthermore, Klose can raise up to $4 million of debt at an interest rate of  rd = 11%, and an additional $4 million of debt at rd = 12%. The CFO estimates that a proposed expansion would require an investment of $6.8 million. What is the WACC for the last dollar raised to complete the expansion?

Explanation / Answer

Total amount required to be raised=$6.8 million

Out of these $1 million retained earnings shall be used to fund the amount

Remaining amount to be raised shall be=$(6.8-1)million

=$5.8 million

After the amount is raised the firm desires a 70% equity and 30 % debt structure

so the amount should be raised as follows

Using common stock=$6.8 million*70%

=$4.76million

Using Debt =$6.8 million*30%

=$2.04 million

Now WACC can be computed using the following formula

=[Cost of debt*Corresponding amount)+(Cost of common stock*corresponding capital)+(COst of retained earnings* Corresponding capital)]/Total capital to be raised

=[(2.04*0.11)+(3.76*0.18)+(1*0.14)]/6.8

=(0.2244+0.6768+0.14)/6.8

=15.31%

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