SB - I might need you to biatch slap my boss…I’m still salty about her cruise last year. 
If you want a followup, I just fumbled this bad boy in qbank tonight: 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) 25%. C) 35%. D) 0%.
Sponge Bob: now that we have the full question… no doubt! the way it was posted sugested the other answer…
For Bannisja’s question is it: WACC = .65 * .12 + .35 * .07 = .1025 Accept projects A, B, and D 4,000,000 * .65 = 2,600,000 (4,000,000-2,600,000)/4,000,000 = .35 = 35% So C Thats a shot in the dark. I always get screwed but not calculating WACC using the cost of retained earnings so I tried it.
nib- you nailed it, nice job.
Wait…why use 12% for cost of equity and not 13.5%?? I got confused about that…
Yeah I used the 13.5% as well, but I guess the reason is pretty simple. There is no need to issue new share capital to finance profitable projects ie: No need to use the incremental rate. So what would happend if you had to finance part of the third project by issueing new shares? I guess you’d have to weight the equity portion of WACC between retained earnings rate and issue new share capital rate?
It looks like I just got lucky with the right answer as here is how I did it…although I see the answer above. After seeing Niblita75’s answer, I feel like I made up an equation to solve this thing…I need to remember to use cost of RE for WACC! C WACC = .65 * .135 + .35 * .07 = .11225 Accept projects A&B $3,500,000 * .65 = $2,275,000 Cost of $2,275,000 equity = $2,275,000*.135 = $307,125 RI = ($4,000,000-$2,275,000-$307,125)/$4,000,000 = $1,417,875/$4,000,000 = 0.354
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%. that’s the official qbank answer. kerry i think says it right- no need to issue more stock at the more expensive rate. i would guess that if you decided you wanted to undertake enough projects that you’d have to go out for new shrs, then it probably would be some sort of weighted average b/t the rates as you stated above. i don’t think the cfa will go that far on a question, thankfully.
Kerry, I think that since the cost of retained earning < cost of issuing new equity, if a project is not worth undertaking with retained earning, it would not be financed by issuing new equity.
not necessarily…if they still want to take up additional projects with additional capital…as long as the returns from the investment are greater than the cost of raising new equity - they still might consider it… I guess…basically if the WACC using the higher cost of equity is still lower than the IRR"s of the remaining projects…they would raise the additional capital…and undertake the projects… make sense? right? or not…?
WACC uses the marginal cost of capital. If you don’t need to raise new equity, then the marginal cost of equity capital is retained earnings. Simple.