Question

1. Chooc possesses common stock selling for $45.00 per share, for some reasons, Chooc expects to earn $3.75 per share during the current year, and he expects a payout ratio is 70%, and constant growth rate is 6.00%. He also will issue new stock to be sold to the public at the current price, with a flotation cost of 8.5% By how much would the cost of new stock exceed the cost of retained earnings (old common stock)?

Answer 1

Cost of retain earnings can be found by using following formula

=D1/Po + g

D1 = Expected dividend

Po = price of share = $45

g = growth rate = 6%

D1 = Expected EPS x Payout ratio

=3.75 x 70%

=2.625$

Thus cost of retain earnings = 2.625/45 + 6%

=0.05833 + 0.06

=0.1183

i.e 11.83%

Now if new shares are to be issued than company would incur floatation cost

Thus price of stock will be adjusted by floatation cost

Thus Po = 45(1-floatation cost)

=45(1-8%)

=45(0.92)

=41.40$

Thus cost of new equity = 2.625/41.40 + 0.06

=0.0634 + 0.06

=0.1234

i.e 12.34%

Thus cost of new equity will exceed cost of retain earnings by 0.51$ (12.34%-11.83%)