Cost of Retained Earnings vs. Cost of Equity company, capital, structure, following, investment

bluejazzy

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) 0%.
B) 35%.
C) 12%.
Your answer: A was incorrect. The correct answer was B) 35%.
First determine the WACC. WACC = wd

chandsingh

*If the company issues new stock.
Only projects A, B, and D will be taken since their IRRWACC
The total investment is $4,000,000 which is equal to retained earnings
They could fund more investment than that if they wanted to but they don’t have attractive opportunities.
Since they have enough retained earnings to fund the investment, they won’t need to issue new stock. Since they won’t have to issue new stock, you shouldn’t include that cost when calculating WACC