Klose Outfitters Inc. believes that its optimal capital structure consists of 70
ID: 2768245 • Letter: K
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 = 12%. New common stock in an amount up to $6 million would have a cost of re = 16%. Furthermore, Klose can raise up to $4 million of debt at an interest rate of rd = 11%, and an additional $3 million of debt at rd = 14%. The CFO estimates that a proposed expansion would require an investment of $6.7 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.
Explanation / Answer
Capital requirement = 6.70 million
Equity financing = 6.70 million x 70% = 4.69 million
Debt Financing = 6.70 million x 30% = 2.01 Million
Out of 4.69 million of equity financing, 2 million will be made through retained earnings and rest of the 2.69 million through common stock issue.
After tax cost of debt = rd x (1-t)
= 11% x (1-0.40)
= 6.60%
Source
Amount
Cost
amt x cost
Debt
2.01
6.60%
0.13266
Retained earnings
2
12%
0.24
Common stock
2.69
16%
0.4304
Total
6.7
0.80306
WACC = sum of amt x cost / total amount
= 0.80306 / 6.70
= 11.99%
Source
Amount
Cost
amt x cost
Debt
2.01
6.60%
0.13266
Retained earnings
2
12%
0.24
Common stock
2.69
16%
0.4304
Total
6.7
0.80306
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