When management of a company intends to raise additional funds, it attempts to maintain its target capital structure. At the same time, such a strategy is limited by the amount of retained earnings. In other words, the amount of new capital that can be raised while the target structure remains the same is called retained earnings breakpoint. If management of a company needs to raise more and also maintain its target capital structure, additional common stock must be issued, but this will result in an increase in the weighted average cost of capital (WACC) due to flotation cost.
The retained earnings breakpoint can be calculated as follows:
|Retained Earnings Breakpoint =||Retained Earnings|
where Retained Earnings is the amount of retained earnings in a given accounting period (not the accumulated amount of retained earnings presented in the balance sheet!) and we is the proportion of common equity in the target capital structure.
The dividend policy of Total S.E. Inc. has set a dividend payout ratio of 32%. The target capital structure is represented by 40% of equity and 60% of debt. The net profit reported in the last quarter amounted to $2,500,000.
We should use the formula above to find the retained earnings breakpoint for Total S.E. Inc.
Retained Earnings = $2,500,000 × (1 - 0.32) = $1,700,000
|Retained Earnings Breakpoint =||$1,700,000||= $4,250,000|
Thus, the management of Total S.E. Inc. is able to raise additional capital of $4,250,000 without issuing new common stock. If the need for additional capital would exceed $4,250,000, management would have two options: (1) issue new common stock and keep the target capital structure unchanged or (2) raise debt financing and violate capital structure, but both options would result in an increase in the weighted average cost of capital.
The relationship between the amount of new capital raised and its cost is shown in the figure below.
If the target capital structure is kept the same, the maximum amount of new capital that can be raised without any change in WACC is limited by the retained earnings breakpoint. If a company’s needs in new capital exceeds this amount and management intends to maintain its target capital structure, new common stock should be issued, but this will entail an increase in the marginal cost of capital.