Question

You are given the following data for a company: Cost of debt = 8%, cost of retained earnings = 12%, cost of new common equity = 14%, tax rate = 35% and retained earnings = $1000. The firms target capital structure is 40% debt and 60% common equity. Compute the following:

A. Retained earnings break point

B. WACC below the RE break point

C. WACC above the RE break point:

Answer 1

Answer-

A. Retained earnings break point

Retained earnings break point is the amount of new capital that can be raised before the target capital structure changes. The company ha to raise additional equity once the retained earnings break point is exceeded.

Retained earnings break point = Retained earnings / Percentage wt. of equity in capital structure
Retained earnings break point = $ 1000 / 60 % = $ 1000 / 0.60 = $ 1666.67

B. WACC below the RE break point

WACC = cost of debt x wt. of debt x ( 1- tax rate) + cost of retained earnings x wt of retained earnings
WACC = 8 % x 0.40 x ( 1 - 0.35) + 12 % x 0.60  [ retained earnings is treated as equity ]
WACC = 8 % x 0.40 x 0.65 + 12 % x 0.60
WACC = 2.08 % + 7.2 %
WACC = 9.28 %

C. WACC above the RE break point

WACC = cost of debt x wt. of debt x ( 1- tax rate) + cost of common equity x wt of common equity
WACC = 8 % x 0.40 x ( 1 - 0.35) + 14 % x 0.60
WACC = 2.08 % + 8.4 %
WACC = 10.48 %