Olsen Outfitters Inc. believes that its optimal capital structure consists of 70

Question

Olsen Outfitters Inc. believes that its optimal capital structure consists of 70% common equity and 30% 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 = 14%. New common stock in an amount up to $8 million would have a cost of re = 18%. Furthermore, Olsen can raise up to $3 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 $8.6 million. What is the WACC for the last dollar raised to complete the expansion?

Explanation / Answer

1st stage: Total amount to be raised = $5.71 million ie:$4 million retained earnings at a cost of 14% + $1.71 million debt (4*0.3/0.7) at a cost of 6.6% (11*0.60)

WACC = (4/5.71)*14 + (1.71/5.71)*6.6 = 9.8 + 1.98 = 11.78%.

2nd stage: Balance amount to be raised = 8.6 - 5.71 = $2.89 million consisting of Debt of 0.87(2.89*0.36) of debt at 6.6% + 2.02 (2.89*0.7) External equity at 18%

WACC = 6.6*0.3 + 18*0.7 = 1.98 + 12.60 = 14.58%

Hence, WACC for the last dollar raised = 14.58%

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