Olsen Outfitters Inc. believes that its optimal capital structure consists of 50

Question

Olsen Outfitters Inc. believes that its optimal capital structure consists of 50% common equity and 50% debt, and its tax rate is 40%. Olsen must raise additional capital to fund its upcoming expansion. The firm will have $1 million of retained earnings with a cost of rs = 14%. New common stock in an amount up to $10 million would have a cost of re = 16%. Furthermore, Olsen can raise up to $3 million of debt at an interest rate of rd = 9% and an additional $5 million of debt at rd = 12%. The CFO estimates that a proposed expansion would require an investment of $5.4 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Explanation / Answer

The investment requirement of $5.4m will comprise of 2.7m in equity and 2.7m in debt

a) 1m retained earnings at rs = 14%

b) 1.7m new stock at rs = 16%

c) 2.7m in debt at rd = 9%

=> WACC = wd x rd x (1 - tax) + we x rs + wne x rs

= 2.7 / 5.4 x 9% x (1 - 40%) + 1 / 5.4 x 14% + 1.7 / 5.4 x 16%

= 10.33%

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