Why do they use (Retained earnings/Equity Weight) to find the breakpoint? What is the relevance of using Retained earnings?
Can someone help with this?
Are you referring to Capital Component Breakpoint? I dont remember seeing Retained Earnings being used there. If it is from elsewhere, please elaborate.
Hi Rus1bus, Yes, it is from capital component breakpoint. I found it used a few times on Schweser Qbank…
Okay gazhoo, let me attempt to explain this. If you have Retained Earnings, then you would want to exhaust those first, before you go to market to raise additional capital, correct? Lets say you accumulated 100 million in Retained Earnings. Now, these Retained Earnings (100 million) could become your Capital Breakpoint, if company was financed with 100% Equity and NO debt. But, for a company which is not financed 100% with Equity, we will need to calculate, how much of Capital would come from Debt simultaneously, if 100 million is provided from Retained Earnings. This we will get from Company’s Target Capital Structure. (i.e. the planned mix of Debt and Equity usage). And the TOTAL of that Debt amount with 100 million of RE would be our Capital Breakpoint. To get that TOTAL, we will need to divide Retained Earnings (100 million) with the weight of Equity in the Capital Structure. Does this clarify? Please let me know, if it is confusing at any point.
Hi, so wouldn’t we divide retained earnings by debt weight?
No gazhoo, we will divide by Equity Weight and not by Debt Weight. Lets take an example. Retained Earnings = 100 million Target Capital = 40% Debt and 60% Equity Our Breakpoint Capital would be the TOTAL Capital (Debt + Equity), after which we will look for any additional financing. We already have 100 million in Equity (as Retained Earnings) But this 100 million is only 60% of the TOTAL Capital. so, if 60% of TOTAL Capital is 100 million therefore, 100% of TOTAL Capital would be (100 million / 60%) x 100% which is equal to 100 million / 0.6 = RE / Equity Weight
ok!!! the connection i didn’t make --> “We already have 100 million in Equity (as Retained Earnings)” Understand now. Thanks again Rus1bus!!!
I think, it should be the total equity that is common stock + retained earnings which will be divided by the equity weight not just retained earnings to calculate the breakeven point.