Question

Check My Work (2 remaining) 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 $2 million of retained earnings with a cost of rs​=12%. New common stock in an amount up to $9 million would have a cost of re​=14.5%. Furthermore, Olsen can raise up to $2 million of debt at an interest rate of rd​=9% and an additional $3 million of debt at rd​=13%. The CFO estimates that a proposed expansion would require an investment of $6.6 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places. %

Answer 1

The Weighted Average Cost of Capital (WACC) is calculated by determining the costs of equity and debt and summing them up based on their respective proportions in the capital structure. In this case, the WACC for the last dollar raised to complete the expansion is 25.15%.

Step-by-step explanation:

The Weighted Average Cost of Capital (WACC) is used to determine the minimum return rate a company needs to make on its investments to satisfy its investors. To calculate the WACC, you need to determine the cost of each source of capital (equity and debt) based on their respective proportions in the capital structure. Then, you multiply the cost of each source by its weight and sum them up to get the WACC.

In this case, we have the cost of equity, the cost of retained earnings, and the cost of debt. We know that the optimal capital structure is 70% equity and 30% debt. So, we can calculate the WACC for the last dollar raised to complete the expansion:

1. Cost of equity: 14.5% x 70% = 10.15%
2. Cost of retained earnings: 12% x 70% = 8.4%
3. Cost of debt (9%): 9% x 30% = 2.7%
4. Cost of debt (13%): 13% x 30% = 3.9%

Now, we can sum up these costs to get the WACC:

WACC = 10.15% + 8.4% + 2.7% + 3.9% = 25.15%

Therefore, the WACC for the last dollar raised to complete the expansion is 25.15%.