The following financial data relates to the Carmichael Beverage Company for 2005: * The target capital structure is 65% equity and 35% debt. * After-tax cost of debt is 7%. * Cost of retained earnings is estimated to be 12%. * Cost of equity is estimated to be 13.5% if the company issues new common stock. * Net income is $4,000,000. Carmichael Beverage Company is considering the following investment projects: Project A: $2,500,000 value; IRR of 11.50% Project B: $1,000,000 value; IRR of 13.00% Project C: $2,000,000 value; IRR of 9.50% Project D: $500,000 value; IRR of 10.50% Project E: $1,500,000 value; IRR of 8.00% If the company follows a residual dividend policy, its payout ratio will be closest to: A) 12%. B) 35%. C) 25%. D) 0%.
B
B WACC = .65(.12) + .35(.07) = .1025 Accept projects A,B,D Totals 4,000,000 Residual = 4,000,000 - .65(4,000,000) = 1,400,000 Dividend Payout = 1,400,000/4,000,000 = .35
D? Looks like there are more profitable projects then budget allows. And I know this is wrong.
Since the projects under consideration are all having +NPV. They better reinvest the NI, instead of paying them out as dividends. So 0%? D?
I think D for the same reason as pinkman
Niblita75 Wrote: ------------------------------------------------------- > B > > WACC = .65(.12) + .35(.07) = .1025 > > Accept projects A,B,D > > Totals 4,000,000 > > Residual = 4,000,000 - .65(4,000,000) = 1,400,000 > Dividend Payout = 1,400,000/4,000,000 = .35 Wow, I’m impressed. This is exactly right. I never would have thought to answer this way. I figured the project stuff was extra info. I bow down to you.
b WACC = .65(12)+.35(7) = 10.25% Any project return less then WACC is rejected That leaves us with A, B and D which have a total Capital requirment of $4m. In order to keep the target cap structure 65% of the $4m for projects must come from Equity. $4m(.65) = $2.6m; This is what we must use out of Net income. the remaining $4m-2.6m=1.4m is what is paid out or 35%
Nib, genious man! I thought the “value” was NPV, which its not… dumb mistake
akanska: Were you maybe thinking about residual income? NI - (beginning equity*cost of equity)?
I’ve seen this question b/f and still got it wrong. That really grinds my gears.
I didn’t get where they were going- didn’t understand NI was projected NI inc’g the projects and that the “value” was cost- thought that was NPV like LanceTX did
B? Same logic as Niblita.
Why is the cost of equity 12% and not 13.5%? I don’t remember hearing the phrase “cost of retained earnings” before.
Its cheaper, you don’t have to go through the costs of issuing new shares through a bank.
now if there was an additional project you would have to calc a new WACC with the higher equity rate b/c in order to maintain the optimal cap structure new equity would have to be issued as all of equity availbile from NI would have been used.
Nice question akanska! never would I had thought that they were not talking of NPV there, when the gave the figures so close to IRR 
There are a million ways to get this question wrong.
AFJunkie Wrote: ------------------------------------------------------- > now if there was an additional project you would > have to calc a new WACC with the higher equity > rate b/c in order to maintain the optimal cap > structure new equity would have to be issued as > all of equity availbile from NI would have been > used. Thanks for the explanation. Now that you 2 have mentioned it I remember it now. This was a tough question.
I just went though another practice question that gave me a “light-bulb” moment… hopefully it will help someone else… the Equity portion of the CapReqmt [.65(4,000,000)] is the Retained Earnings!! Thats what I was missing- the NI is unrelated to income from the new projects… restated: equity portion of CapBudget in T+1 is retained from earning in T… so (NI t - equity%(CapBudget t+1))/ NI t = payout