Question

BJK Inc.’s common stock currently sells for $150.00 per share, the company expects to earn $27.50 per share during the current year, its expected payout ratio is 70%, and its expected constant growth rate is 6.00%. New stock can be sold to the public at the current price, but a flotation cost of 7.7% would be incurred. By how much would the cost of new stock exceed the cost of retained earnings?

Answer 1

Expected Dividend (D1) = Expected earnings x Dividend payout = $27.50 x 70% = $19.25

Growth rate (g) = 6%, Current stock price (P0) = $150,

Flotation costs (F) = $150 x 7.7% = $11.55

Only difference between cost of retained earnings and cost of new common stock is the Flotation costs which will incurred only when issuing new stock.

Cost of retained earnings = [ D1 / P0 ] + g = [ $19.25 / $150 ] + 0.06 = 0.18833333333 or 18.83%

Cost of new common stock = [ D1 / (P0 - F) ] + g = [ $19.25 / ($150 - $11.55) ] + 0.06 = 0.19903936439 or 19.90%

Excess cost of new common stock = 19.90% - 18.83% = 1.07%