Question

Bill's Barbecue Store Company has 50 stores currently. The company targets a 40% Debt to Total Assets ratio - therefore any capital project will be funded with 40% debt and 60% equity. The company's weighted average cost of capital is 8.5% at this target leverage level.

The company has the following expansion plans for the upcoming year: 1) 10 new store locations in Indiana, which will require an investment of $600,000 and has a projected IRR (internal rate of return on investment) of 11%; and 2) 15 stores in Michigan with a total cost of $900,000 and a forecasted IRR of 10.5%. The company's net income was $1,500,000 for the past 12 months and management follows the residual policy with regards to its dividends. Based on this information, the company will need to retain as retained earnings how much of its net income as equity funding for the capital projects that are projected to generate returns on the investment that exceed its WACC (hint: what is total investment amount of qualifying projects and how much will be funded by equity, i.e., the retention of earnings (some of the cash needed for the two projects will be debt funding as stated above)?

A $1,500,000

B $360,000

C $780,000

D $900,000

Answer 1

The earnings are also part of equity as they are accumulated in retained earnings and shown under stockholder's equity account.
The company has debt equity ratio of 40% and 60%.
Therefore the projects would be financed 40% by debt and 60% by equity that is by retained earnings.
The total cost of two projects is $1,500,000 ($600,000+$900,000)
Therefore amount to be financed from retained earnings would be $1,500,000*60%	$900,000
Thus, company will have to retain $900,000 net income as equity funding for the capital projects.
The balance would be funded through issue of debt.