CFA Level 1: Retained Earnings Breakpoint Calculation

Retained Earnings Breakpoint Calculation

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Question

A firm has a target dividend payout ratio of 36% and net income of $1.7 million. It is committed to maintaining an optimal capital structure consisting of 63% debt and 37% equity. The firm is in the 40% tax bracket. Its retained earnings breakpoint equals ________.

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A. B. C. D. E. F. G.

E

The retained earnings breakpoint refers to the maximum amount of capital that can be raised using retained earnings, assuming a constant capital structure and dividend payout ratio. In other words, it is the maximum amount of capital that can be raised without increasing the marginal cost of capital. In the present example, the maximum internal equity capital equals 1.7 * 0.64 = $1.088 million. To maintain a D/E ratio of 63/37 = 1.7, the amount of debt to be issued equals

1.088 * 1.7 = $1.85 million. Therefore, earnings break-point equals (1.088 + 1.85) million = $2.938 million.

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