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 $2,700,000. What is the WACC for the last dollar raised to complete the expansion?

Explanation / Answer

Answer: Based on the firm’s indicated optimal capital structure mix of 70% equity and 30% debt financing, the $2700,000 expansion should be funded in the following proportions:

Equity financing = $2700000× 0.70 = $1890,000

Debt financing = $2700,000× 0.30 = $810000

Equity financing components to total $1890,000:

1)$300000 of retained earnings at a cost of retained earnings (rs) = 15% –Weight for retained earnings (ws) = $300000/$2700000= 0.1111

2)$1590000 of new common stock at a cost of new common stock (re) =20% – Weight for new common stock (we) = $1590000 / $2700000= 0.5889

Debt financing component to total $810000:

1)$250000 of debt at a before-tax cost of debt (rd) = 6% – Weight for debt (wd) = $250000 / $2700000 = 0.09259

2) $560000 of additional debt at a before-tax cost of debt (rd) = 8% – Weight for debt (wd) = $560000 / $2700000 = 0.2074

The average overall WACC can be calculated as:

However, the WACC for the last dollar of the expansion involves issuing 30% ($0.30) debt at a cost of 8% and 70% ($0.70) new common stock at acost of 20%. Thus the WACC applicable to the last dollar of expansion financing is:

WACC for last dollar = (0.3000)(0.08)(0.65) + (0.7000)(0.20) =15.56%

Capital structure Amount Weight Cost of capital WACC Retained earnings 300000 0.111111 15% 1.67% New common stock 1590000 0.588889 20% 11.78% Debt 250000 0.092593 3.90% 0.36% Additional Debts 560000 0.207407 5.20% 1.08% Total 2700000 14.88%

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