Question

3.Clipton Enterprises Inc just paid a dividend of $1.85. Dividends are expected to grow at a constant rate of 7.5% per year, and the stock price is currently $19.25. New stock can be sold at this price subject to flotation costs of 8%. The company's marginal tax rate is 35%. Compute the cost of internal equity (retained earnings) and the cost of external equity (new common stock), respectively.

Answer 1

“ Cost of Internal Equity (Retained Earnings) = 17.83% “

“ Cost of External Equity (New Common Stock) = 18.73% “

Computations

Cost of Internal Equity (Retained Earnings)

P0 = D1 / [ Ke – g ]

$19.25 = $1.98875 / [Ke – 0.075]

[Ke – 0.075] = 0.1033

Therefore, Cost of Equity[Ke]

= 0.1033 + 0.075

= 0.1783 or

= 17.83%

Cost of External Equity (New Common Stock)

Next Year Dividend (D1) = D0 x [1+g] = $1.85 x 1.075 = $ 1.98875 per share

Market Price of the Share(P0) = $19.25 per share

Growth Rate (g) = 7.50%

Flotation Cost (Fc) = 8%

Flotation - Adjusted cost of equity = [ D1 / Po ( 1 – Fc ) ] + g

= [$ 1.98875 / $19.25 ( 1 – 0.08 ) ] + 0.075

= [ $1.98875 / $17.71 ] + 0.075

= 0.1123 + 0.075

= 0.1873 or

= 18.73%