Question

Murray Motor Company wants you to calculate its cost of common stock. During the next 12 months, the company expects to pay dividends (D1) of $3.00 per share, and the current price of its common stock is $60 per share. The expected growth rate is 8 percent.

a. Compute the cost of retained earnings (Ke). (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.) Cost of retained earnings___%
b. If a $5 flotation cost is involved, compute the cost of new common stock (Kn). (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
Cost of new common stock ____%

Answer 1

a. Compute the cost of retained earnings (Ke)

$60 = $3 / (Ke - 8%)

Ke - 8% = $3 / $60 = 5%

Ke = 13%

b. If a $5 flotation cost is involved, compute the cost of new common stock (Kn).

$60 (1 - $5/$60) = $3 / (Kn - 8%)

$55 = $3 / (Kn - 8%)

Kn - 8% = $3 / $55 = 5.45%

Kn = 13.45%

Flotation costs reduce the amount of money that the company receives for every new stock that it issues, therefore, it increases the cost of new stocks.