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Cost of Retained Earnings/WACC and Optimal Capital Budgeting

XYZ company's investment budget and dividend payout plan for next year.

a. XYZ expects next year's income after-tax to be $28,000,000.
b. Earnings and dividends are growing at a constant rate of 10% per year.
c. Last year's dividends was $2.73,
d. Current stock price is $40.00
e. Cost of new debt is 12%
f. XYZ's optimal capital structure is 70% equity and 30% debt.
g. Marginal Tax rate is 40%
h. The following independent and equally risky investment opportunities are available.

Project Cost IRR
A $10,000,000 17%
B $5,000,000 15%
C $8,000,000 13%
D $7,000,000 16%
E $3,000,000 14%

Questions:

1. What is XYZ's cost of it's retained earnings?

2. What is the company's after-tax weighted average cost of capital?

3. What is the dollar amount of XYZ's optimal capital budget and which projects should be undertaken?

4.In terms of the "pure residual theory of dividends" (applied in the short run for only next year), how much (in dollars) should XYX's plan to pay out in dividends to it's share holders?

Solution Preview

Please see attachment.

XYZ Company's investment budget and dividend payout plan for next year.

a. XYZ expects next year's income after-tax to be $28,000,000.
b. Earnings and dividends are growing at a constant rate of 10% per year.
c. Last year's dividends was $2.73,
d. Current stock price is $40.00
e. Cost of new debt is 12%
f. XYZ's optimal capital structure is 70% equity and ...

Solution Summary

The cost of retained earnings/WACC and optimal capital budgeting is examined.

$2.19