WACC for residual income

Am referring to Schweser, chapter 27, dividends and share repurchases, challenge problem 16. Question says target capital structure is 50% debt and 50% equity. After tax cost of debt = 8%; cost of retained earnings = 13.5%; cost of equity =14.5% if the company issues new stock. The answer requires first calculating WACC, which they give as (0.5 x 0.08) + (0.5 x 0.135). Why do they use the cost of retained earnings and not the cost of equity to calculate WACC?

I beleive this ties into Pecking Order theory whereby a company wants to use internally generated funds prior to issuing new equity.

But i haven’t seen “cost of retained earnings” anywhere in the CFAI text, so not sure i would spend a ton of time thinking about this!

I think they’re being fancy with how to account for the equity charge or RI, strange question


I really think this has to be an inconsistency. Logically (I could be incorrect), but I would assume that the with calculating residual income, since you have RI = E - equity charge, where equity charge is just rr on equity times the BV, it doesnt seem logical to use WACC.

It might seem confusing to many, because it’s not a residual income question… it’s a residual dividend policy question. ro24, you are correct… it’s a question revolving around pecking order theory where internally generated funds are preferred to that of issuing new, more costly, equity. The question asks to calculate the payout ratio under the assumption of a residual dividend policy.