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 $2 million of retained earnings with a cost of rs = 13%. New common stock in an amount up to $6 million would have a cost of re = 17%. Furthermore, Klose can raise up to $3 million of debt at an interest rate of rd = 10%, and an additional $3 million of debt at rd = 13%. The CFO estimates that a proposed expansion would require an investment of $7.6 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Explanation / Answer

1) Calculation WACC for the project expansion cost :

Justification : Given Cost of retained earnings = 13%              = 2million

                                Cost of equity                 = 17%              = 6million

                                Cost of Debt(After tax) = 6% (10-40%) = 3million

Cost of Debt(After tax) = 7.8% (13-40%)= 3million

We need $7.6 million for project expansion,however we have sources for $14 millions.So that we should select the sources with lower cost. Since cost of equity was showing 17% cost we should eliminate it first.And now we have sourches for $8million however we need $7.6million,Comparing these three projects retained earnings had more cost that is 13% so we need to reduce the capital from retained earnings to $1.6 million.

        For WACC purposes after tax cost of capital shall be taken.

Source $millions Proportion Cost after tax Weighted cost Retained earnings 1.6 0.21 0.13 0.03 Debt@10% 3.0 0.39 0.06 0.02 Debt@13% 3.0 0.39 0.078 .0318 Total 7.6 0.0818 WACC (%)P.a 8.18

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