If a firm needs additional capital from equity sources once its retained earning
ID: 2615354 • Letter: I
Question
If a firm needs additional capital from equity sources once its retained earnings breakpoint is reached, it will have to raise the capital by issuing new common stock False: Firms raise capital from retained earnings only when they cannot issue new common stock due to market conditions outside of their control. True: Firms will raise all the equity they can from retained earnings before issuing new common stock, because capital from retained earnings is cheaper than capital raised from issuing new common stock. White Lion Homebuilders is considering investing in a one-year project that requires an initial investment of $500,000. To do so, it will have issue new common stock and will incur a flotation cost of 2.00%. At the end of the year, the project is expected to produce a cash inflow of $550,000. The rate of return that White Lion expects to earn on its project (net of its flotation costs) is (rounded to two decimal places) Alpha Moose Transporters has a current stock price of $33.35 per share, and is expected to pay a per-share dividend of $1.36 at the end of next year. The company's earnings' and dividends' growth rate are expected to grow at the constant rate of 5.20% into the foreseeable future. If Alpha Moose expects to incur flotation costs of 5.00% of the value of its newly-raised equity funds, then the flotation-adjusted (net) cost of its new common stock (rounded to two decimal places) should be White Lion Homebuilders Co.'s addition to earnings for this year is expected to be $420,000. Its target capital structure consists of 40% debt, 5% preferred, and 55% equity. Determine white Lion Homebuilders's retained earnings breakpoint: O $954,545 O $801,818 $687,272 O $763,636Explanation / Answer
Answer:
True:Firms will raise all the equity they can from retained earnings before issuing new stock, because capital from retained earnings is cheaper than capital raised from issuing new common Stock.
White Lion Home Builders
The rate of return:
$500000 / ( 1 - 0.02) = $510204.08
($550000 - $510204.08) / $510204.08 = 7.8%
Alpha Moose Transporters
Floatation adjusted cost = D1/[Po(1-F)] + g = $1.36 / [$33.35 ( 1 - 0.05)] + 0.052
Floatation adjusted cost = [ $1.36 / 31.6825 ] + 0.052 = 9.49%
White Lion Home Builders
A Firms prefer to raise capital from retained earnings instead of issuing new stock whenever possible, because no flotation costs are associated with raising capital from retained earnings. However, if a firm has more good investment opportunities than can be financed with retained earnings, it may need to issue new common stock. The retained earnings (RE) breakpoint is the total amount of capital that can be raised before a firm must issue new common stock. RE Breakpoint Addition to Retained Earnings for the Year/ Equity Fraction of Target Capital Structure $420,000 / 0.55 $763,636 Finding the retained earnings breakpoint of $763,636 tells you that this is the total amount of capital that White Lion Homebuilder’s can raise without having to issue new common stock while maintaining its target capital structure.
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