Question

Sons' common stock currently trades at $30.00 a share. It is expected to pay an annual dividend of $3.00 a share at the end of the year (D1​=$3.00), and the int orowth rate is 6% a year. a. What is the company's cost of common equity if all of its equity comes from retained eamings? Do not round intermediate calculations. Round your answer to two dedinal places. b. If the company issued new stock, it would incur a 10% 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

The company's cost of common equity if all of its equity comes from retained earnings is 16%. If the company issued new stock incurring a 10% flotation cost, the cost of equity from the new stock would be approximately 17.11%.

Step-by-step explanation:

The company's cost of common equity, when all equity comes from retained earnings, can be calculated using the Gordon Growth Model which is expressed as:

Cost of Equity = (D1 / P0) + g

where D1 is the next year's expected annual dividend, P0 is the current stock price, and g is the growth rate.

For Sons' common stock, we have:

Cost of Equity = ($3.00 / $30.00) + 0.06

Cost of Equity = 0.10 + 0.06 = 0.16, or 16%.

For part b, calculating the cost of equity from new stock, we need to adjust the price to account for the flotation cost. This can be done by multiplying the current stock price by (1 - flotation cost percentage). The adjusted cost of equity formula will then be:

Cost of New Equity = (D1 / (P0 * (1 - Flotation Cost))) + g

Cost of New Equity = ($3.00 / ($30.00 * (1 - 0.10))) + 0.06

Cost of New Equity = ($3.00 / $27.00) + 0.06 = 0.1111 + 0.06 ≈ 17.11%