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) 0%. D) 35%.
this was posted earlier in the day D
Your dividend thing was tough.
D by memory from earlier.
oh, whoops- goes to show what happens when you work all day! dumb question- in calculating WACC can you always take the lower of cost of equity or retained earnings? i was doomed from the get go on this…
hmm i got 43% so would pick d w/out further calc
bannisja Wrote: ------------------------------------------------------- > oh, whoops- goes to show what happens when you > work all day! > > dumb question- in calculating WACC can you always > take the lower of cost of equity or retained > earnings? i was doomed from the get go on this… No, you use the higher cost of new equity if you require new equity to finance the projects, cost of retained earnings if external financing not required as in this case. At leaset that’s my opinion.
if i use 12% as cost of equity then i get 35% b/c we accept hte 500k project. not sure why not to use 13.5%
perfect- that makes sense swanny. appreciate you taking the time to type that out. for anyone who didn’t see the explanation before: 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%.
good question.
that happens to be the % of debt… we can skip all these calculation and conclude it is the % of debt during exam - saves lots of time.