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 35%. Klose must raise additional capital to fund its upcoming expansion. The firm will have $300,000 of retained earnings with a cost of 15%. New common stock in an amount up to $6 million would have a cost of 20%. Furthermore, Klose can raise up to $250,000 of debt at an interest rate of 6% and an additional $6 million of debt at 8%. The CFO estimates that a proposed expansion would require an investment of $3,700,000. What is the WACC for the last dollar raised to complete the expansion?

Explanation / Answer

Calculation of amount of Capital required from each source Total Capital Required = $3,700,000 Amount of Common Equity Required = 70% of $3,700,000                                                                     =$2,590,000 Amount of Debt Required = 30% of $3,700,000                                                 =$1,110,000 Statement of Required Funds Equity Debt Total Required 2590000 1110000 Less: Retained Earnings 300000 - New Equity Required 2290000 - Debt @ 6% - 250000 Debt @ 8% 860000 Calculation of WACC Nature of Fund Amount Cost of Capital Weight Weighted Cost of Capital Retained Earning 300000 15% 0.08 1.22% New Common Equity 2290000 20% 0.62 12.38% Debt @ 6% 250000 3.90% 0.07 0.26% Debt @ 8% 860000 5.20% 0.23 1.21% Total 3700000 WACC 15.07% Note 1: Cost of debt(kd) = Interest Rate (1-Tax Rate) a) For 6% debt, kd = 6%(1-35%)                                   =3.9% b) For 8% debt, kd = 8%(1-35%)                                   =5.2%

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