The WACC is a weighted average of the cost 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 some 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?

The answer is:

Question 1: WACC will be lower if the equity came solely from retained earnings.

Question 2: Yes, WACC depends on the size of the capital budget

Question 3: Dividend policy affects WACC. The The higher the firm’s dividend payout, the smaller the addition to retained earnings and this will make the WACC higher

Explanation:

Weighted Average Cost of Capital (WACC) is the rate at which a company will pay for raising finances. Company raises money issuance of new shares, issuance of note or bonds(debts). The WACC is also the same as Cost of Capital.

Question 1: WACC are going to be different if the equity for the approaching year came solely from retained earnings. WACC are going to be lower if equity comes solely from retained earnings because the price of retained earnings is zero or smaller than if new equity is issued.

Question 2: WACC does rely on the dimensions of the capital budget. If usage of retained earnings is above new equity, WACC will decrease and vice-versa.

Question 3. Dividend policy affects WACC. If a firm’s dividend payout is high, there will be smaller addition to retained earnings and this will make the WACC to increase and vice-versa

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