Olsen Outfitters Inc. believes that its optimal capital structure consists of 60

Question

Olsen Outfitters Inc. believes that its optimal capital structure consists of 60% common equity and 40% debt, and its tax rate is 40%. Olsen must raise additional capital to fund its upcoming expansion. The firm will have $3 million of retained earnings with a cost of rs = 12%. New common stock in an amount up to $7 million would have a cost of re = 15%. Furthermore, Olsen can raise up to $3 million of debt at an interest rate of rd = 10% and an additional $4 million of debt at rd = 11%. The CFO estimates that a proposed expansion would require an investment of $6.9 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Explanation / Answer

IInvestment of 6.9 million can be funded as: 60%*6.9=4.14 million equity (out of which 3 million retained earnings) and 40%*6.9=2.76 million debt

Hence WACC of last dollar raised=0.6*15%+0.4*10%*(1-40%)=11.4%

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