WACC Klose Outfitters Inc. believes that its optimal capital structure consists
ID: 2714347 • Letter: W
Question
WACC 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 $7 million would have a cost of re = 18%. Furthermore, Klose can raise up to $2 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 $5.4 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.
Explanation / Answer
Target Capital structure = 30% equity and 70% debt
Tax rate = 40%
Retained earnings = $ 1 Million
Cost of retained earnings rs = 14% or 0.14
Cost of equity for new Common stock = 17%
Amount upto which common stock can be raised = $ 8 Million
Cost of $ 4 Million of Debt = 9%
Cost of Additional $ 3 Million of Debt = 12%
Additional Funds required for expansion = $ 4.6 Million
Expected amount of Equity funding for proposed investment = $ 4.6 Million * 0.30
= $ 1.38 Million
Expected amount of debt funding for proposed investment = $ 4.6 Million - $ 1.38 Million
= $ 3.22 Million
The firm utilises its retained earnings in the first step
The firm next raises $ 3.22 Million by issuing new debt at 9%
The firm finally issues new equity to the tune of $ 0.38 Million (= 4.6 – 1 – 3.22) of new equity
Weights of various sources of financing in proposed investment
Retained Earnings = $1 Millon/$4.6 Million = 0.2174
Debt = $ 3.22 Million / $ 4.6 Million = 0.70
Equity = $ 0.38 Million / $ 4.6 Million = 0.0826
As equity is expected to be raised last, WACC applicable for the last dollar of finance will be
WACC = wt of RE * Cost of RE + Wt of debt * cost of debt * (1-tax rate) + wt of equity * cost of equity
WACC = 0.2174 * 14% + 0.7 * 9% * (1-0.40) + 0.0826 * 17%
WACC = 3.0436% + 3.78% + 1.4042%
WACC = 8.2278% or 8.23% (rounded off)
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