Math Problem Statement
46.00 0.08asPercent 2.30 1.50 1.50
Question content area top Part 1 Retained earnings versus new common stock Using the data for a firm shown in the following table, calculate the cost of retained earnings and the cost of new common stock using the constant-growth valuation model. (Click on the icon here in order to copy the contents of the data table below into a spreadsheet.) Current market price per share
Dividend growth rate
Projected dividend per share next year
Underpricing per share
Flotation cost per share $46.00 8 %
$2.30 $1.50 $1.50 Question content area bottom Part 1 a. The cost of retained earnings is 13 %. (Round to two decimal places.) Part 2 b. The cost of new common stock is 13.17 %. (Round to two decimal places.)
Solution
To calculate the cost of retained earnings and the cost of new common stock using the constant-growth valuation model, we use the following formulas:
1. Cost of Retained Earnings ():
The cost of retained earnings is the required return on the firm's stock. It can be estimated using the Gordon Growth Model (also called the Dividend Discount Model), given by:
Where:
- = Projected dividend per share next year = $2.30
- = Current market price per share = $46.00
- = Dividend growth rate = 8% = 0.08
2. Cost of New Common Stock ():
The cost of new common stock takes into account flotation costs and underpricing. The formula is similar to that of retained earnings but adjusted for the underpricing and flotation costs:
Where:
- = Underpricing per share + Flotation cost per share = $1.50 + $1.50 = $3.00
Step-by-step Calculation:
a. Cost of Retained Earnings ():
b. Cost of New Common Stock ():
Final Answers:
- a. The cost of retained earnings () is 13%.
- b. The cost of new common stock () is 13.35%.
Would you like further clarification or details? Here are some additional questions to explore:
- How does flotation cost impact the cost of issuing new stock?
- Can the growth rate be negative, and how would it affect the cost of retained earnings?
- What is the difference between underpricing and flotation cost in stock issuance?
- How would a higher dividend growth rate affect the cost of equity?
- What other models can be used to calculate the cost of equity apart from the constant-growth model?
Tip: When calculating the cost of new common stock, always remember to subtract flotation and underpricing costs from the current market price.
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Math Problem Analysis
Mathematical Concepts
Finance
Constant Growth Model
Cost of Equity
Formulas
Cost of Retained Earnings: r_e = (D_1 / P_0) + g
Cost of New Common Stock: r_n = (D_1 / (P_0 - F)) + g
Theorems
Gordon Growth Model (Dividend Discount Model)
Suitable Grade Level
Undergraduate Finance, MBA
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