Hey all I’m confused on a schweser question (q16 in chapter 30, page 317 in the corp finance book). Basically it asks you to calculate a WACC and gives you the ‘cost of retained earnings’ at 13.5% and the ‘cost of equity if company issued new stock’ at 14.5%. I used the 14.5% figure because I thought you always used market values (ie the cost of new debt or equity). but in the answer, they’ve used the figure for cost of retained earnings. Any ideas why? The question is about how to implement a residual dividend policy, does that make a difference? (because i guess you are funding the expenditure with internal cashflow, ie retained earnings, rather than selling stock…) I wish they had explained the logic. Thanks everyone for your help.
While making any financing decision, chepaest cost of finance will be retained earning, after that debt and then external equity. In case of redidual dividened policy, It has to be retained earning which will be applied for dividend distribution.
I haven’t read that yet, but don’t necessarily agree with it…not your response Krishna, but rather the text. I see what they’re getting at but those retained earnings (and thereby, the company cash) is cash that still belongs to the shareholders. Should it therefore not reflect their required rate of return (Ke)? We use cost of equity in a DDM when we’re discussing shareholder dividends, and if the company didn’t distribute the cash then the shareholders would surely expect a return of at least the actual cost of equity, and not retained earnings. Interesting…
I would always just assume that if they’re asking about a divident policy or a project which would be funded internally you would use the ‘cost of retained earnings’ and then if it were a question about a project using external financing then you would use the cost of issuing new equity. The Cost of issuing new equity is always going to be higher because of float and dillution. So in the case of a dividend policy we’re not facing any float cost or dillution.
I had some epic arguments in school with a treasury management professor who kept refering to Retained Earnings as free capital. He put this multiple choice question on every exam that Asked what was the cheapest form of financing a)Debt b)equity c)retained earnings. I answered A everytime and then we’d argue. Just cause it doesn’t cost you anything to acquire retained earnings, investors do require a return, so if you’re not going to generate that return with the money then you should just pay it all out in a dividend.