Calculating WACC with Cost of Retained Earnings

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clip1989

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I am doing an example in the QBank, and they give the after tax cost of debt, cost of issuing new equity, and the cost of retained earnings. In calculating the WACC, they use the cost of retained earnings instead of the cost of issuing new equity, which confused me because I have always seen the cost of equity used. Could someone please clarify?
Thank you!
 
What’s the actual question? Is it evaluating a project?
I think if you are evaluating potential projects or have determined that there is enough retained earnings to fund a project than there is no need to issue new equity so you’d use the cost of retained earnings.
 
Here is the question:
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:
 
since cost of retained earnings is LOWER than the cost of issuing new equity - the preference would be to use the retained earnings for new project investment – not sure if this is covered in the Corp Fin material anywhere.
 
This is good for my studying. Ok….
“Residual dividend policy” in last line is key…so company will use the NI of $4 million towards capex and then pay what is left over in dividends.
So, then you plug and chug with the 12% and see the wacc is 10.25% so you’d pull the trigger on project A,B,D for a total of $4 million in capex and then plug it into the target structure that’d give you .65x4mil=2.6mil in equity with 1.4 leftover for dividends and then the payout ratio is the 1.4 leftover / NI of 4mil to get .35.
 
JACT calc is right, another key to this question is the pecking order theory, preference financing is internal funds > debt > new equity
 
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