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The WACC is a weighted average of the costs of debt, preferred stock, and common equity....

The WACC is a weighted average of the costs of debt, preferred stock, and common equity. Would the WACC be different if the equity for the coming year came solely in the form of retained earnings versus equity from the sale of new common stock? Would the calculated WACC depend in any way on the size of the capital budget? How might dividend policy affect the WACC? Please explain.

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Answer:

Answer to Part (1):

The cost of using the retained earnings for financing capital is lower than the cost of using the new equity obtained from sale of new commons stock as a means for financing capital.

Therefore : with all other components of WACC remaining unchanged WACC will decrease if the equity of the coming year is coming from retained earnings.

Answer to Part (2):

The calculation of WACC depends upon the size of a firm's capital budget .In order to determine the size of the capital budget a firm calculates its retained earnings breakpoint (as well as any other breakpoint for taking on additional debt or issuing preferred shares).The retained earnings breakpoint represents the amount of capital raised beyond which the firm will have to issue new common stock for raising capital.Thus if the firm's capital budget is lower than this breaking point then the firm will use the lower cost retained earnings and thus WACC will decrease on the other hand if the capital budget is higher than this breaking point then the firm will use the higher cost issue of new equity shares and thus WACC will increase.

Answer to Part (3):

Dividend Policy has a substantial impact on the WACC of a firm.The higher the firm's dividend payout will be lower will be the addition to the retained earnings and hence lower the retained earnings breakpoint and hence higher the WACC and vice-vera.

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