Klose Outfitters Inc. believes that its optimal capital structure consists of 50

Question

Klose Outfitters Inc. believes that its optimal capital structure consists of 50% common equity and 50% debt, and its tax rate is 40%. Klose must raise additional capital to fund its upcoming expansion. The firm will have $2 million of retained earnings with a cost of rs = 12%. New common stock in an amount up to $9 million would have a cost of re = 15%. Furthermore, Klose can raise up to $4 million of debt at an interest rate of rd = 9%, and an additional $5 million of debt at rd = 12%. The CFO estimates that a proposed expansion would require an investment of $7.1 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Explanation / Answer

Tax rate = 40%

Retained earnings = $2,000,000

Cost of rs = 12%

Common Stock = $9,000,000

Cost of re = 15%

Debt = $4,000,000

Cost of rd = 9%

After tax cost of debt = 9% X (1 - 40%) = 5.4%

Additional Debt = $5,000,000

Cost of rd = 12%

After tax cost of debt = 12% X (1 - 40%) = 7.2%

Weighted Average Cost of Capital = 0.1083 = 10.83%

Note:

Proportion

Retained Earnings = $2,0000,000/$20,000,000 = 0.1

Common Stock = $9,000,000/$20,000,000 = 0.45

Debt = $4,000,000/$20,000,000 = 0.2

Additional Debt = $5,000,000/$20,000,000 = 0.25

Sources (A) Amount (B) Proportion (C ) After tax cost (D) Weighted cost (E = C X D) Retained Earnings 2,000,000 0.1 12% 0.0120 Common Stock 9,000,000 0.45 15% 0.0675 Debt 4,000,000 0.2 5% 0.0108 Additional Debt 5,000,000 0.25 7% 0.0180 Total 20,000,000 1 0.1083

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