Question

Jarett & Sons's common stock currently trades at $27.00 a share. It is expected to pay an annual dividend of $2.50 a share at the end of the year (D1 = $2.50), and the constant growth rate is 4% a year. What is the company's cost of common equity if all of its equity comes from retained earnings? Do not round intermediate calculations. Round your answer to two decimal places. % If the company issued new stock, it would incur a 12% flotation cost. What would be the cost of equity from new stock? Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

Cost of common equity assuming equity comes from retained earning = 13.26%

Cost of common equity from new stock = 14.52%

Step-by-step explanation:

From the constant growth model:
`P0=(D1)/(ke-g) \\`

where P0=$27; D1=$2.50; g = 4%

If the company is using retained earnings, it does not incur any flotation costs as it just retains earnings instead of paying them out as dividends.

therefore from the above equation, if we solve for ke, we get:

`ke=(D1)/(P0)+g = (2.5)/(27)  +0.04 = 13.26%`

If the company issues new stock, it will effectively receive less that $27 per share as 12% will have to go towards flotation costs. ke in this case will be:

`ke=(D1)/(P0(1-f)) +g = (2.5)/(27(1-0.12)) +0.04=14.52%`

Flotation costs effectively increase cost of capital.