# CFAI Question

Apologies in advance if this has already been posted: Target Optimal Capital Structure: Long Term Debt: 50% Preferred Stock: 10% Common Equity: 40% After tax component costs: Long term debt 6% Preffered Stock 10% Retained Earnings 14% New Common Stock 15% Expected Earnings: 120 million Target Dividend Payout Ratio: 45% If the company raises 150 million in new capital, the company’s marginal cost of capital is closest to: a) 9.6% b) 10% c) 14% d) 15% Answer: (.5 x 6%) + (.1 x 10%) + (0.4 x 14%)= 9.6 Alright two questions on this, please don’t point and laugh: 1) Why is that we are using 14% instead of 15% in this calculation? I am assuming that it is because cost to draw from retained earnings is less than issuing common stock? (especially after accounting for floatation costs etc.)…Is this a hard and fast rule (IE if retained earnings is less than cost to issue common stock ALWAYS draw from retained earnings?)…Or does the dividend payout ratio have to be taken into account as well when considering this? 2) When it comes to weighted average cost of capital and marginal cost of capital are they the same thing? Schweser states that they are, but I justed wanted to confirm that they are in fact one in the same. Thanks Dubs

1. Look at RE for previous year: 150 * .55 = 66 Million If all RE was ploughed back into Company --> Amount of Equity they could possibly get is 66 / .4 = 165M (Based on 40% equity) . So now they want 150 Million --> and since that falls below the 165M that they could possibly get from ploughing back RE into the company --> Cost of Retained Earnings needs to be used here. (At least this is what they have done in the solution to the question). Probably HiredGuns, Chebychev, Super I or Joey – how does this sound? When you plough back retained earnings into the company – is it reasonable to assume that you are going to get the entire amount from there? Isn’t it reasonable to assume that 66/150 would be at a 14% rate, while 84 M/150 would be at 15% and calculate the WACC based on that? CP

cpk123 Wrote: ------------------------------------------------------- > Probably HiredGuns, Chebychev, Super I or Joey – > how does this sound? When you plough back retained > earnings into the company – is it reasonable to > assume that you are going to get the entire amount > from there? Isn’t it reasonable to assume that > 66/150 would be at a 14% rate, while 84 M/150 > would be at 15% and calculate the WACC based on > that? > > CP Yes, it is. I saw two similar questions in the L-I CFAI online exams.

ruhi, I am a little confused. Which is the way to approach the problem? The way CFAI has done it in the soln… which is used the 14% for the entire Equity? Or the way I am suggesting (66 @ 14% and 84 @ 15%).4

i think the question had said they don’t wanna issue more shares…hope that helps

@ cpk123: I agree with your reasoning and I’m pretty sure that if a prob like that comes up on the exam, you should be using the RE cost for the entire equity amount, provided the breakpoint is higher than the amount they’re trying to raise. @ Dubs: remember there’s that formula about the breakpoint in the optimal capital budget, where the breakpoint = RE / %of equity in the capital structure. So once you get that breakpoint, compare it with the amount they’re trying to raise. If: breakpoint > amt to be raised – use RE cost breakpoint < amt to be raised – use new common equity cost I think that’s the foolproof rule you’re after hth

niraj_a Wrote: ------------------------------------------------------- > i think the question had said they don’t wanna > issue more shares…hope that helps nope no reference to not wanting more shares issued

lola makes sense i believe.

lola Wrote: ------------------------------------------------------- > @ cpk123: I agree with your reasoning and I’m > pretty sure that if a prob like that comes up on > the exam, you should be using the RE cost for the > entire equity amount, provided the breakpoint is > higher than the amount they’re trying to raise. > > @ Dubs: remember there’s that formula about the > breakpoint in the optimal capital budget, where > the breakpoint = RE / %of equity in the capital > structure. So once you get that breakpoint, > compare it with the amount they’re trying to > raise. If: > > breakpoint > amt to be raised – use RE cost > breakpoint < amt to be raised – use new common > equity cost > > I think that’s the foolproof rule you’re after > > hth Thanks for your responses everyone, Lola to the rescue as usual

This is not bad question at all. My thinking: Since (120 * 0.55) = 66 > (150 % 0.4) = 60. So there is enough retained earning to support the optimal capital structure. Since we do not need to issue new stocks, use retained earnings cost . Let me know if this is correct. I type too slow. There are a million post since I read this.

I agree with your logic cpk: the marginal cost of capital is equal to the weighted cost of capital because no new capital needs to be raised. If they needed to raise 500 million, the would need to go back out to debt and equity markets, and the marginal cost of capital could be higher than the weighted average cost of capital. Leverage acts as a multiplier to the amount of capital that can be generated with a dollar of equity. Here, the leverage ratio is 2.5, so you can fund \$165 worth of capital projects with the \$66 from retained earnings. The assumption is that the difference is made up with preferred stock (\$16.5) and debt (\$82.5). The result is no change in the capital structure. It is for the same reason that we see the leverage multiplier in the Du Pont equations. Adding debt usually increases ROE (provided interest expense is not unduly large), because instead of funding a project that generates say \$10 with \$100 in equity (and getting an ROE of 10%), you fund it with say \$40 in equity and \$60 in debt (getting an ROE of 25%). ROE was increased by a factor of the leverage multiplier of 2.5. One question for the group: assume they wanted to raise \$166 million in capital (i.e., one million from an outside source). Wouldn’t we need to use both the cost of retained earnings and the cost of new equity in a weighted average to calculate the marginal cost of capital (rather than ignoring the cost of retained earnings and using only the cost of new equity).

TheDubs Wrote: ------------------------------------------------------- > Thanks for your responses everyone, > Lola to the rescue as usual any time, Dubs hope I’m right though. That’s how I’ve been rationalizing it all along, but if SuperI is reading this thread, I’d be happy to get his thoughts on this as well.

chebychev Wrote: ------------------------------------------------------- > I agree with your logic cpk: the marginal cost of > capital is equal to the weighted cost of capital > because no new capital needs to be raised. If > they needed to raise 500 million, the would need > to go back out to debt and equity markets, and the > marginal cost of capital could be higher than the > weighted average cost of capital. > > Leverage acts as a multiplier to the amount of > capital that can be generated with a dollar of > equity. Here, the leverage ratio is 2.5, so you > can fund \$165 worth of capital projects with the > \$66 from retained earnings. The assumption is > that the difference is made up with preferred > stock (\$16.5) and debt (\$82.5). The result is no > change in the capital structure. > > It is for the same reason that we see the leverage > multiplier in the Du Pont equations. Adding debt > usually increases ROE (provided interest expense > is not unduly large), because instead of funding a > project that generates say \$10 with \$100 in equity > (and getting an ROE of 10%), you fund it with say > \$40 in equity and \$60 in debt (getting an ROE of > 25%). ROE was increased by a factor of the > leverage multiplier of 2.5. > > One question for the group: assume they wanted to > raise \$166 million in capital (i.e., one million > from an outside source). Wouldn’t we need to use > both the cost of retained earnings and the cost of > new equity in a weighted average to calculate the > marginal cost of capital (rather than ignoring the > cost of retained earnings and using only the cost > of new equity). Yes, so it would mean that 1/166 would be the wt of the new equity cost ( from outside ) .

Am i right to say tht 66 million would be used from retained earnings and remaining will be borrowed or we need to borrow the whole amt ?

I just read lola’s explanation and I think that is what I would go with. The question in the exam shouldn’t get more complicated than this. cpk, you would go with 14% for the entire equity bcoz you are not issuing any new common stock. hope that helps.

thanks, ruhi How’s your studying for L2 going?

Could someone please tell me which LOS this is? I can’t find any thing about Cost of Retained Earnings in CFAI Curriculum ( I’m assuming book 4 Corp Fin and Port Mgmt?) Also, does the full question tell you last years earnings? And that the firm doesn’t want to issue stock? Cos its not in the posted question. Thanks a lot

lola Wrote: ------------------------------------------------------- > thanks, ruhi How’s your studying for L2 going? Not too bad! I’m getting there…slowly and not-so-steadily The L-II forum is quite dead currently.

yickwong Wrote: ------------------------------------------------------- > Could someone please tell me which LOS this is? I > can’t find any thing about Cost of Retained > Earnings in CFAI Curriculum ( I’m assuming book 4 > Corp Fin and Port Mgmt?) > > Also, does the full question tell you last years > earnings? And that the firm doesn’t want to issue > stock? Cos its not in the posted question. > > Thanks a lot the question is posted exactly as it was listed, no further information was provided…not sure which los sepcifically it applied too