CFA Practice Question

CFA Practice Question

Your company's stock sells for $50 per share, its last dividend was $2.00, its growth rate is a constant 5 percent, and the company would incur a flotation cost of 15 percent if it sold new common stock. Net income for the coming year is expected to be $500,000, the firm's payout ratio is 60 percent, and its common equity ratio is 30 percent. If the firm has a capital budget of $1,000,000, what component cost of common equity will be built into the WACC for the last dollar of capital the company raises?
A. 11.75%
B. 10.50%
C. 9.94%
Explanation: BP(RE) = RE/Equity fraction = $500,000(0.4)/0.3 = $666,667.
BP = break point; RE = retained earnings
Since the capital budget will be $1 million, and since all equity in the WACC beyond $666,667 will be external equity, the WACC of the last dollar raised will include equity at a cost of k(e): k(e) = $2(1.05)/$50(1 - 0.15) + .05 = 9.94%.

User Contributed Comments 4

User Comment
timspear I guess this is based on k(e)=D1/(P0(1-F))+ g from our notes but the formula seems a bit silly in only applying flotation costs to the D1 bit. What about a company with negligable dividends that is growing 10% and issues shares? Do the flotation costs not exist in that case?
mishis timspear: it is not applying flotation costs to D1 but to price.

However, can someone explain the Break even equation given plssss? Would the answer be the same if the capital budget were 666,667?
chandsingh In my view if the capital budget is 666,667 then external equity would not be required so you would not need to worry about the flotation costs etc. That is why they worked it out first.
skarthi146 mishis, my understanding is that: break point is the level of capital company can raise without altering its capital structure (this means without raising additional debt or equity). Since the capital budget of 1M is beyond the Break point, the company will issue new equity which will include the floatation cost.

I think, if the capital budget is less than or equal to 666,667 then I guess the company's existing cost of equity will apply (which can be calculated using the same formula without adjusting the dr by (1-0.15)
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