Question

Olsen Outfitters Inc. believes that its optimal capital structure consists of 65% common equity and 35% debt, and its tax rate is 25%. Olsen must raise additional capital to fund its upcoming expansion. The firm will have $3 million of retained earnings with a cost of rs = 13%. New common stock in an amount up to $7 million would have a cost of re = 14.5%. Furthermore, Olsen can raise up to $4 million of debt at an interest rate of ra = 11% and an additional $4 million of debt at rd = 12%. The CFO estimates that a proposed expansion would require an investment of $4.8 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Answer 1

Calculate the WACC for the last dollar raised as follows:

The firm’s capital structure contains 65% common equity and 35% of debt.

Tax rate is 25%

	Proportion	Cost of capital	Prop × Cost of capital
Equity	65%	14.5%	9.425%
Debt	35%	8.25% (WN)	2.8875%
WACC			12.31%

Therefore, the WACC for the last dollar raised is 12.31%.

Working Note:

Therefore, the after-tax cost of debt is 8.25%