The management of a conservative firm has adopted a policy of never letting debt exceed 30...

Question:

The management of a conservative firm has adopted a policy of never letting debt exceed 30 percent of total financing. The firm will earn $10,000,000 but distributed 40% in dividends, so the firm will have $6,000,000 to add to retained earnings. Currently the price of the stock is $50; the company pays a $2 per share dividend, which is expected to grow annually at 10%. If the company sells new shares, the net to the company will be $48.

a. What is the cost of retained earnings

b. What is the cost of new common stock?

Retained Earnings:

A company pays dividends to its shareholders from the net income. The undistributed portion of net income is added to the retained earnings which means that retained earnings represent the net income is not distributed as dividends. Retained earnings are used for the purpose of reinvestment by the company. Retained earnings are part of stockholders' equity as such they belong to the ultimate owners of the company.

Answer and Explanation:


Answer:

a) The cost of retained earnings is 14.40%.

Explanation:

As per the data:

  • Last dividend, D0 = $2
  • Constant growth rate, g = 10%
  • Current stock price, P0 = $50
  • Cost of retained earnings =?

Computation:

The first step is to determine the next dividend, D1:

  • D1 = D0 * (1 + g)
  • D1 = $2 * (1 + 10%)
  • D1 = $2.20

The second step is to determine the Cost of retained earnings:

  • Cost of retained earnings = (D1/P0) + g
  • Cost of retained earnings = ($2.2 / $50) + 10%
  • Cost of retained earnings = 14.40%

b) The cost of new common stock is 14.58%

Computation:

  • Cost of new common stock = (D1/P0) + g
  • Cost of new common stock = ($2.2 / $48) + 10%
  • Cost of new common stock = 14.58%

Learn more about this topic:

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The Dividend Growth Model

from Finance 101: Principles of Finance

Chapter 14 / Lesson 3
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