WineCellars Inc.currently has a weighted average cost of capital of 12%.WineCellars has been growing rapidly over the past several years,selling common stock in each year to finance its growth.However,due to difficult economic times this year,WineCellars decides to cut its dividend and increase its retained earnings so that the common equity portion of its capital structure will include only retained earnings and no new common stock will be sold.WineCellars' weighted average cost of capital this year should be

Question

Quizplus · Accepted Answer

By cutting its dividend and increasing its retained earnings, WineCellars will reduce its cost of equity capital, since the cost of equity is based on the amount of dividends paid to shareholders. As a result, the weighted average cost of capital for WineCellars should be less than 12%. However, the precise cost of capital depends on the specific composition of the firm's capital structure and the relative weight of debt and equity in the structure.