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

Current market price per share (P0) = $150

Expected EPS = $27.50

Payout ratio = 70%

So, Dividend = 27.50*70% = $19.25

Growth rate = 6% or 0.06

Cost of retained earnings = D1/P0 + g

= 19.25/150 + 0.06

= 0.1883 or 18.83%

Cost of new equity = D1/(P0*(1-flotation). + g

= 19.25/(150*(1-7.7%)). +. 0.06

=19.25/138.45. + 0.06

= 0.1990 or 19.90%

So cost of new equity exceeds cost of retained earnings = 19.90% - 18.83%

= 1.07%

So cost of new quity exceeds cost of retained earnings by 1.07%

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