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?
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A. B. C. D. E.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%.