WACC Olsen Outfitters Inc. believes that its optimal capital structure consists
ID: 2804522 • Letter: W
Question
WACC Olsen Outfitters Inc. believes that its optimal capital structure consists of 55% common equity and 45% debt, and its tax rate is 40%. Olsen must raise additional capital to fund its upcoming expansion. The firm will have $4 million of retained earnings with a cost of rs 11%. New common stock in an amount up to $8 million would have a cost of re = 12.5%. Furthermore, Olsen can raise up to $4 million of debt at an interest rate of 10-10 = 9% and an additional $5 million of debt at rd = 13%. The CFO estimates that a proposed expansion would require an investment of $8.2 million. What is the WACC for the last dollar raised to complete the expansion?Explanation / Answer
Proposed expansion = $8.2 million and this will be raised in equity 55% and debt 45%.
Thus amount to be raised through new common stock = 55% of $8.2 million = $4.51 million
Amount to be raised through debt = 45% of $8.2 million = $3.69 million
Amount of retained earnings (as provided in the question) = $4 million. Thus new equity that will be raised will be = 4.51 million - 4 million = 0.51 million. Amount of debt (as computed above) = 3.69 million
Weight of retained earnings = 4/8.2 = 0.487805. Weight of equity = 0.51/8.2 = 0.062195. Weight of debt = 3.69/8.2 = 0.45
Now upto $4 million of debt will be raised at 9%. Thus cost of debt here is 9% (as debt required is $3.69 million and this is lower than $4 million).
WACC for last dollar raised = weight of retained earnings*cost of retained earnings + weight of new common stock*cost of new common stock + weight of debt*cost of debt
= 0.487805*11% + 0.062195*12.5% + 0.45*9%
= 10.19329% or 10.19% (rounded off to 2 decimal place).
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