Your company is expected to earn $4.0 million in net income next year of which it will pay out 40% in dividends. If equity represents 50% of your capital, what is the breakpoint on the MCC where new stock will have to be issued?

Question

Quizplus · Accepted Answer

The breakpoint on the Marginal Cost of Capital (MCC) schedule where new stock will have to be issued is calculated by dividing the total amount of dividends by the percentage of equity in the capital structure. The company plans to pay out 40% of its $4.0 million net income in dividends, which equals $1.6 million ($4.0 million * 40%). Since equity represents 50% of the capital structure, the breakpoint is $1.6 million divided by 50%, or $3.2 million. However, the correct calculation should consider the total net income available for reinvestment in the business (retained earnings), not just the dividend payout. The retained earnings are 60% of $4.0 million (100% - 40% payout ratio), which equals $2.4 million. This amount is what's available for reinvestment before needing to issue new equity. Given the choices provided and the correct approach to calculate the breakpoint based on retained earnings, none of the explanations perfectly match the correct calculation method, indicating a misunderstanding in the initial explanation. The correct calculation for the breakpoint should involve the retained earnings and the proportion of equity financing, but the provided choices and explanation seem to misalign with this method.

Your Company Is Expected to Earn $4