when we compute WACC, the cost of equity is the cost of retained earnings or the cost to issue new euity. i came accross a q. that had both of these and i choose cost of issuing new equity and i was wrong… i am confused…
Depends on which one is lower of the two. If the Cost of retained earnings is lower than the cost of Equity – the company is better off ploughing all its retained earnings back – and generate the new capital from there, rather than going to the market and generating new equity there. This was one of the questions in the CFAI institute tests in L1 (probably 2006 stuff) and there was a lot of commentary on this from hiredguns1 in the posts close to the December exam. I will post the link once I find it, but you could search for it, as well. Edit: Found the link and added it here http://www.analystforum.com/phorums/read.php?11,636689,636721#msg-636721 CP
nikko, can you post the question for us? My understanding is that we must be informed as to whether the company will use retained earnings or intends to raise external equity. Given the choice, a company would prefer to use retained earnings which are less costly than external equity due to flotation costs and negative signaling to the marketplace.
If the project is so large that you’ll have to issue new equity to finance it, you’ll have to account for the flotation cost in your wacc (i.e. that would be the required rate of return PLUS flotation costs) If the project is small, you’ll just take the cost of retained earnings (i.e. that would be the required rate of return)
schweser pg 114 #18 the q is too long to type out. hiredguns1 if you dont have schweser let me know and i will type it out… basically they used the R?E to calculate the cost of equity… going by CP … the cost of R/E in this question was lower than the cost of new equity… so thinking that way makes sense…