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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

WACC Olsen Outfitters Inc. believes that its optimal capital structure consists of 55% common equity and 45% 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 = 11%. New common stock in an amount up to $8 million would have a cost of re = 12-5%. Furthermore, Olsen can raise up to $4 million of debt at an interest rate of rd = 9% and an additional $5 million of debt at rd = 13%. The CFO estimates that a proposed expansion would require an investment of $8.2 million. What is the WACC for the last dollar raised to complete the expansion?

Summary Introduction

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

Introduction:

Weighted Average Cost of Capital (WACC):

WACC is the weighted average cost of capital of all the sources through which the firm can finance its capital. It is the rate that the company will pays to all for raising finance. It can be termed as the cost of capital of a firm. 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.

Explanation

Given information:

Cost of debt is 9% or 0.09.

Weight of debt is 45%

Cost of equity is 12.5% or 0.125

Weight of equity is 55%

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 0.45 for Wd , 0.09 for rd 0.125 for rc , 0.55 for Wc and 0.40 for t in above formula.

=0.45×0.09(10

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