Schweser hit me with a WACC problem where they gave me the following Cost of equity is estimated to be 13.5% if the company issues new common stock. Cost of retained earnings is estimated to be 12%. I got it wrong because I used 13.5 as cost of equity and they said I should have used 12% Its a bit sneaky. Has anyone else seen the equity component given this way?

I haven’t seen this before, but at first glance I would probably go with 12%, only cause it says the cost of equity is 13.5% if the company issues NEW common stock. WACC reflects the current capital structure, so the cost of issuing new equity isn’t relevant. Although cost of retained earnings would make me scratch my head a bit cause R/E is only one component of equity …

It sounds like a special problem to me; one that requires knowledge of the question and background info. My first thought would be cost of retained earnings would be based on a historical WACC (you used a mix of debt + equity to generate those earnings in the past) where as the cost of equity would be based only on equity cost of capital and probably be forward looking

Well, they just gave a list and these where the only two related to equity and no other background information.

Umm, this has relation to other material. Pecking order theory i guess. Any company would first prefer to use retained earnings, then debt and last choice would be equity. :slight_smile: sneaky but interesting.

My best guess is that this would be a question concerning residual dividend policy. And accordingly, the idea is to fund the equity portion of your upcoming capital budget with the help of retained earning to the greatest extent possible, and what remains is distributed to shareholders. The idea is that when you issue new equity, there are floatation costs involved and therefore, funding your project from internally generated funds is cheaper. I’m not sure about this.

If I remember correctly from level 1 WACC is calculated on the “Marginal Cost of Capital” which would be the 13.5 so I’d disagree with schweser on this one. In either case, there isn’t a single case in the CFAI curriculum where this happens, sounds like a left over question from a time that this was actually included in the curriculum. That’s one problem with Schweser/Stalla,I was just doing some PassMaster problems and for the term structure reading, they threw some bootstrapping questions which are not tested (Level I)

Schweser is correct. If the firm has enough money in RE to fund the project, the cost of equity is the internal cost (cost of RE). If the firm requires to issue stock this is externally generated and raises the cost of equity because of the issue costs. Just pay close attention to how much the firm needs to raise (in equity that is), and use the cost of internally generated equity (cheaper) if they have enough. If they need to issue stock, then use the higher amount (cost of equity after issuing stock).