ABC Corp. forecasts that if all of its existing financial policies are followed,

Question

ABC Corp. forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than retained earnings, ABC would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock?

a. Increase the dividend payout ratio fro the upcoming year

b. increase the percentage of debt in the target capital structure

c. increase the proposed capital budget

d. reduce the amount of short-term bank debt in order to increase the current ratio

e. reduce the percentage of debt in the target capital structure

Explanation / Answer

b. increase the percentage of debt in the target capital structure

a. Wrong. This would lead to decrease in retained earnings and so increase the need to issue new common stock.

b. Correct. This would reduce the need of new common stock as debt would be used in lieu of equity, given the fact cost of debt is less than cost of equity.

c. Wrong. This would increase the need for capital funding.

d. Wrong. Reduction in bank debt has to be replaced by new stock/ equity, so the need for new stock would increase.

e. Wrong. Reduction in debt percentage would increase the need for new stock.

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