Question

10-2: Basic Definitions WACC Klose Outfitters Inc. believes that its optimal capital structure consists of 65% common equity and 35% debt, and its tax rate is 40%. Klose must raise additional capital to fund its upcoming expansion. The firm will have $2 millior of retained earnings with a cost of rs 15%. New common stock in an amour to $9 million would have a cost of re-: 17%. Furthermore, Klose can raise up to $3 million of debt at an interest rate of rd 9%, and an additional $4 nillion of debt at rd--12%. The CFO estimates that a proposed expansion ould require an investment of $5.0 million. What is the WACC for the last ollar raised to complete the expansion? Round your answer to two decimal laces. up

Answer 1

1)	Component cost:
	Cost of retained earnings (given)	15.00%
	Cost of common equity (given)	17.00%
	After tax cost of debt (upto debt of $3 million) = 9%*(1-40%) =	5.40%
	After tax cost of debt (for further debt of $4 million) = 12%*(1-40%) =	7.20%
2)	Debt required for $5 million = 5*35% =	$         1.75	million
	Equity required for $5 million = 5*65% =	$         3.25	million
	Retained earnings available	$         2.00	million
	New equity required = $3.25 million-$2.00 million =	$         1.25	million
3)	First stage Capital structure:
	Retained earnings	$         2.00	million
	Debt = 2*35%/65% =	$         1.08	million
	Total	$         3.08	million
	Second stage capital structure:
	Balance to be raised = 5-3.08 =	$         1.92	million
	Debt 35% and new equity 65%
	WACC of last dollar raised = 5.40%*35%+17%*65% =	12.94%
	Note:
	Cost of debt upto $2 million is 5.40%. Total debt
	upto capital requirement of $5 million is 1.75% only.
	Hence, cost of debt is in the first slab; is 5.40%.