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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

WACC Klose Outfitters Inc. believes that its optimal capital structure consists of 60% common equity and 40% debt and its tax rate is 40%. Klose must raise additional capital to fund its upcoming expansion. The firm will have $3 million of retained earning, with a cost of rs = 12%. New common stock in an amount up to $6 million would have a cost of re = 15%, furthermore. Klose can raise up to $3 million of debt at an interest rate of rd = 10% and an additional $4 million of debt at rd = 12% The CFO estimates that a proposed expansion would require an investment of $5.9 million. What is the WACC for the last dollar raised to complete the expansion?

Summary Introduction

To determine: The WACC for last dollar to complete the expansion.

Weighted average cost of capital

It is the weighted average cost of capital of all the sources through which firm finances its capital. It is that rate that company will pay to all for raising finance. It can be termed as firm’s cost of capital.

The company raises money through various sources such as common stock, preference share debt the WACC is calculated taking the relative weight of each item of capital structure.

The formula of WACC is:

WACC=Wdrd(1t)+WPrp+Wcrs

Where

  • Wd is the weight of the debt.
  • WP is the weight of the preferred stock.
  • Wc is the weight of the equity.
  • rd is cost of the debt.
  • rP is cost of the preferred stock.
  • rc is the cost of the equity.
Explanation

Given,

Cost of debt is 10% or 0.10.

Weight of debt is 40%

Cost of equity is 15% or 0.15

Weight of equity is 60%

The company does not have any preferred stock the WACC can be calculated as

WACC=Wdrd(1t)+Wcrs

Where

  • Wd is the weight of the debt.
  • Wc is the weight of the equity.
  • rd is cost of the debt.
  • rc is the cost of the equity.

Substitute 0.40 for Wd, 0.10 for rd 0.15 for rc, 0.60 for Wc and 0.40 for t in above formula.

=0.40×0.10(10.40)+0

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