The Global Advertising Company had net income after interest but before taxes of $40,000 this year. The marginal tax rate is 40 percent, and the dividend payout ratio is 30 percent. The company can raise debt at a 12 percent interest rate. The last dividend paid by Global was $0.90. Global's common stock is selling for
$8.59 per share, and its expected growth rate in earnings and dividends is 5 percent. If Global issues new common stock, the flotation cost incurred will be 10 percent. Global plans to finance all capital expenditures with 30 percent debt and 70 percent equity. What is the break point due to retained earnings being used up?
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A. B. C. D. E.B
Calculate net income and retained earnings
EBT$40,000 -
Less: Taxes$16,000 -
NI$24,000 -
RE = 0.70($24,000) = $16,800.
Break point retained earnings:
BP(RE) = $16,800/0.70 = $24,000.
To calculate the break point due to retained earnings being used up, we need to determine the amount of financing obtained through retained earnings. Retained earnings are the portion of net income that is reinvested back into the company rather than paid out as dividends.
First, let's calculate the amount of dividends paid by the company. We know that the dividend payout ratio is 30%, and the net income after interest but before taxes is $40,000. Therefore, the dividends paid can be calculated as:
Dividends = Net Income * Dividend Payout Ratio Dividends = $40,000 * 0.30 Dividends = $12,000
Next, we need to calculate the amount of financing obtained through equity. We can use the dividend discount model to calculate the value of the equity:
Equity Value = Dividends / (Cost of Equity - Growth Rate) Equity Value = $12,000 / (0.05 - 0.05) Equity Value = $12,000 / 0.00 (Note: Here, the growth rate and the cost of equity are the same at 5%) Equity Value = Undefined
Since the equity value is undefined, it means that the financing obtained through equity is exhausted or used up. Therefore, the break point due to retained earnings being used up is equal to the total amount of financing obtained through equity, which is $12,000.
However, the question states that the company plans to finance all capital expenditures with 30% debt and 70% equity. This implies that the company will not issue new common stock until the retained earnings are fully exhausted. Therefore, the break point due to retained earnings being used up is $12,000.
The correct answer is C. $10,000.