Retained Earning Breakpoint
Retained earning breakpoint is the level of capital that the company can raise without issuing new common stock. It is the highest point company can raise capital before the capital structure is changed. We will require to issue additional common stock when the company excess this point. It means that the company will covert the remaining retain earnings to raise the fund, it will not impact the percentage of current shareholders as the retained earnings consist of all shareholder percentages.
When we equity structure change, the existing shareholders will lose control over the company as we have to give up some percentage for new shareholders. Moreover, it will impact our cost of capital as well. By using the retain earning, the company will use the previous profit to finance for new projects which are also known as an equity investment. This money supposes to transfer to shareholders in terms of dividends, but the company uses to invest for more profit in the future. At the same time, it also increases the share price as well.
Retained Earning Breakpoint Formula
|R/E Breakpoint = Retained Earning / We|
We: is the percentage of equity in the capital structure.
Company ABC has made a profit of 2,000,000 during the year and there is no dividend during the year. The company wants to keep the capital structure of 60% in debt and 40% in equity. Please calculate the retain earning breakpoint.
Retain Earning Breakpoint = 2,000,000 / 40% = 5,000,000
It means that the company can raise funds of $ 5,000,000 without issuing new common stock. If the management wishes to raise more than this amount, it will impact the capital structure. They can raise by issuing new common stock or debt, both methods will increase the company’s WACC.