A company expects to earn $17 million in income this coming year. Its target capital structure is...

Question:

A company expects to earn $17 million in income this coming year. Its target capital structure is 30% debt, 15% preferred stock, and 55% common equity financing. The company normally pays a dividend equal to 30% of its earnings. At what point will its WACC move from one level to the next, based upon the need to issue new common shares, assuming it adheres to its target capital structure? At what total capital investment level? Show your answer in millions of dollars with one decimal point ($34,000,000 you would record as 34.0)

Dividend:

Dividend refers to the amount which is paid to the shareholders from the earnings after all the other payments are made. One part of net income is retained by the company to fulfill the future needs and other part is distributed as dividend.

Answer and Explanation:

The payout ratio is 30% which implies the retention ratio is 70% (1-0.30).

Amount retained by the company is $11.9 million ($17.0 X 70%).

The capital requirement is fulfilled by the retained amount is 55% of the additional requirements and the remaining 45% would be raised through preference stock of 15% and 30% of debt.

Additional capital with the same capital structure is calculated as follows:

{eq}\begin{align*}{\rm\text{Additional Capital}} &= {\rm\text{Retained Amount + Additional Amount}}\\&= \$11.9{\rm\text{ million}} + \left( {\dfrac{{\$11.9{\rm\text{ million}}}}{{55\% }} \times 45\% }\right)\\&= \$21.6{\rm\text{ million}}\end{align*} {/eq}

So, up to $21.6 million, company need not to issue additional common stock and the WACC will not move.


Learn more about this topic:

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What Is Financing? - Definition & Types

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