The Evanec Company's next expected dividend, D1, is $3.18; its growth rate is 6%, and its common...

Question:

The Evanec Company's next expected dividend, D1, is $3.18; its growth rate is 6%, and its common stock now sells for $36.00. New stock (external equity) can be sold to net $32.40 per share.

a) What is Evanec's cost of retained earning, rs?

b) What is Evanec's percentage flotation cost, F?

c) What is Evanec's cost of new common stock, re?

Cost of Retained Earnings and Cost of New Stock:

The cost of retained earnings is the required rate of return on the firm's current equity capital. The cost of new stocks, however, is typically higher than the cost of retained earning due to flotation costs.

Answer and Explanation:

a) We can use the dividend growth model to compute the cost of retained earnings as follows:

  • cost of retained earnings = next dividend / current stock price + dividend growth rate
  • cost of retained earnings = 3.18 / 36 + 6%
  • cost of retained earnings = 14.83%

b) The percentage flotation cost is the percentage difference between current stock price and new stock price, i.e.,

  • flotation cost = (36 - 32.4) /36
  • flotation cost = 10%

c) We can use the dividend growth model to compute the cost of new stock as follows:

  • cost of retained earnings = next dividend / price of new stock + dividend growth rate
  • cost of retained earnings = 3.18 / 32.4 + 6%
  • cost of retained earnings = 15.75%

Learn more about this topic:

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Cost of Capital: Flotation Cost, NPV & Internal Equity

from Corporate Finance: Help & Review

Chapter 3 / Lesson 18
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