Question

Sentry Manufacturing just paid a dividend $5 per share. The dividend is expected to grow at a

constant rate of 6% per year. The price of Sentry Manufacturing's stock today is $32 per share. If
Sentry Manufacturing decides to issue new common stock, flotation costs will equal $2.70 per
share. Sentry Manufacturing's marginal tax rate is 35%. Based on the above information, the cost
of new common stock (external equity) is
A) 23.72%.
B) 24.09%.
C) 25.26%.
D) 24.52%.

Answer 1

The cost of new common stock for Sentry Manufacturing, after adjusting for flotation costs and accounting for dividend growth, is calculated using the dividend growth model and is found to be B) 24.09%.

Step-by-step explanation:

To calculate the cost of new common stock for Sentry Manufacturing, we need to use the dividend growth model (also known as the Gordon growth model), adjusting for the flotation costs associated with issuing new stocks. The model is represented by the following formula:

Cost of new equity (re) = (D1 / (P0 - F)) + g

Where:

• D1 is the dividend expected next year,
• P0 is the current stock price,
• F is the flotation cost per share, and
• g is the constant growth rate of dividends.

Thus, the expected dividend next year (D1) is $5 * (1 + 6%) = $5.30. The current stock price is $32 and the flotation costs are $2.70 per share. The growth rate (g) is 6%. Plugging these values into the formula gives:

re = ($5.30 / ($32 - $2.70)) + 6%

= ($5.30 / $29.30) + 6%

= 18.09% + 6%

= 24.09%%

Therefore, the correct answer is B) 24.09%.