Klose Outfitters Inc. believes that its optimal capital structure consists of 65
ID: 2761476 • Letter: K
Question
Klose Outfitters Inc. believes that its optimal capital structure consists of 65% common equity and 35% debt, and its tax rate is 40%. Klose must raise additional capital to fund its upcoming expansion. The firm will have $5 million of retained earnings with a cost of rs = 13%. New common stock in an amount up to $8 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 $6 million of debt at rd = 12%. The CFO estimates that a proposed expansion would require an investment of $9.6 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.
Explanation / Answer
A proposed expansion would require an investment of $9.6 million. To maintain optimal capital structure 65% of this 9.6 million should come from equity and remaining from debt.
Thus 65%*9.6=6.24 Million should come from equity and 3.36 from debt.
Now out of 6.24 equity capital 5Million would come from retained earnigns and resr 1.24 from issue of common stock. 3.36 Million debt would be raised at rd=9%.
WACC= weight of retained earnings*cost of retained earnings+Weight of common stock* cost of common stock+ weight of debt*after tax cost of debt
= (5/9.6)*13%+(1.24/9.6)*15%+(3.36/9.6)*(1-40%)*9%
WACC for the last dollar raised to complete the expansion=10.60%
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