Cost of Retained Earnings vs. Cost of Equity

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) 0%. B) 35%. C) 12%. Your answer: A was incorrect. The correct answer was B) 35%. First determine the WACC. WACC = wd × kd(1 - t) + we × ks, where ks is the required return on retained earnings. WACC = (0.65)(0.12) + (0.35)(0.07) = 0.078 + 0.0245 = 0.1025 = 10.25%. Second, decide to accept projects A, B, and D since they are all greater than the WACC. Accepting these projects will result in a total capital budget of ($2,500,000 + $1,000,000 + $500,000) = $4,000,000. The equity portion is 65% × 4,000,000 = $2,600,000. From Carmichael’s net income, $4,000,000 - $2,600,000 = $1,400,000 will be left over for dividends, which implies a payout ratio of $1,400,000 / $4,000,000 = 35%. Why do we use cost of R.E. instead of cost of equity?

*If the company issues new stock. Only projects A, B, and D will be taken since their IRR>WACC The total investment is $4,000,000 which is equal to retained earnings They could fund more investment than that if they wanted to but they don’t have attractive opportunities. Since they have enough retained earnings to fund the investment, they won’t need to issue new stock. Since they won’t have to issue new stock, you shouldn’t include that cost when calculating WACC


goats - so this questions was pretty easy since the NI generated for the year was matching the capital rationing and the capital needed to fund new projects, so there was really no need to issue new stocks. But can somebody explain me how do we go about the calculations if say there was a need to issue news stocks. Say, your NI = 4000K and rationed capital needed is 8000K, target D = 35%, target E = 65% Equity needed = 8000K*0.65 = 5200K > NI of 4000K So now? - no dividends?

I think that is what the residual dividend policy indicates should happen.