Question

Cost of common stock equity Ross Textiles wishes to measure its cost of common stock equity. The firm's stock is currently selling for $41.16. The firm just recently paid a dividend of $3.97. The firm has been increasing dividends regularly. Five years ago, the dividend was just $2.99.

After underpricing and flotation costs, the firm expects to net $38.28 per share on a new issue.

a. Determine average annual dividend growth rate over the past 5 years. Using that growth rate, what dividend would you expect the company to pay next year?

b. Determine the net proceeds, Nn, that the firm will actually receive.

c. Using the constant-growth valuation model, determine the required return on the company's stock, r Subscript srs, which should equal the cost of retained earnings, r Subscript rrr.

d. Using the constant-growth valuation model, determine the cost of new common stock, r Subscript nrn.

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a.The average annual dividend growth rate over the past 5 years is ___ (Round to two decimal places.)

Using that growth rate, the dividend you expect the company to pay next year is ___ (Round to two decimal places.)

b.The net proceeds, Nn, the firm will actually receive are ___ (Round to two decimal places.)

c.Using the constant-growth valuation model, the cost of retained earnings, r Subscript srs, is ____ (Round to two decimal places.)

d.Using the constant-growth valuation model, the cost of new common stock, r Subscript nrn, is ____ (Round to two decimal places.)

Answer 1

a. Current dividend = $3.97, Dividend five years ago = $2.99,

To find the average annual growth rate of dividend over 5 years, we will find compounded average growth rate

Average annual growth rate of dividends = (Current dividend / Dividend five years ago)^{1/no of years} - 1

Average annual growth rate of dividends = (3.97 / 2.99)^1/5 - 1 = (1.327759)^1/5 - 1 = 1.0583366 - 1 = 0.0583366 = 5.83366% = 5.83% (rounded to two decimal places)

The average annual dividend growth rate over the past 5 years is 5.83%

Next year dividend = Current dividend x ( 1 + Average annual growth rate of dividends) = 3.97 x (1 + 5.83%) = 3.97 x 1.0583 = 4.20145 = $4.20

Using that growth rate, the dividend you expect the company to pay next year is $4.20

b. It is given that after Underpricing and flotation cost, firm expects to net $38.28 per share on new issue

Hence Net proceeds firm will actually receive = Net proceeds after Underpricing and flotation cost = $38.28

The net proceeds, Nn, the firm will actually receive are $38.28

c. Current share price = $41.16,

Next year dividend = $4.20, Growth rate of dividends = 5.83% (as calculated above)

Using constant growth rate model, we get

Cost of retained earnings = (Next year dividend / Current share price) + Growth rate of dividends = (4.20 / 41.16) + 5.83% = 10.2040% + 5.83% = 16.0340% = 16.03% (rounded to two decimal places)

Using the constant-growth valuation model, the cost of retained earnings = 16.03%

d. Net proceeds firm will actually receive = $38.28

Next year dividend = $4.20, Growth rate of dividends = 5.83%

Using constant growth rate model, we get

Cost of new common stock = (Next year dividend / Net proceeds firm will actually receive) + Growth rate of dividends

Cost of new common stock = (4.20 / 38.28) + 5.83% = 10.9717% + 5.83% = 16.8017% = 16.80%

Using the constant-growth valuation model, the cost of new common stock = 16.80%