Question

1. Analysts of the ICM Corporation have indicated that the company is expected to grow at a 5 percent rate for as long as it is in business. Currently ICM’s stock is selling for $70 per share. The most recent dividend paid by the company was $5.60 per share. If ICM issues new common stock, it will incur flotation costs equal to 7 percent. ICM’s marginal tax rate is 35 percent. What is its cost of retained earnings—that is, its retained earnings (internal equity)? What is ICM’s cost of new equity?

2. Sholegg Resurfacing plans to retain $125,000 of its income this year for rein- vestment. Financial analysts have deter- mined that the firm’s after-tax cost of debt, rdT, is 4.8 percent, its cost of internal equity (retained earnings), rs, is 9 percent, and its cost of external equity (new common stock), re, is 11.5 percent. Sholegg expects to finance capital budgeting projects so as to maintain its current capital structure, which consists of 55 percent debt. Sholegg has no preferred stock. What will Sholegg’s marginal cost of capital be if its total capital budgeting needs are $300,000 for the year?

Answer 1

1)	Cost of retained earnings as per the Constant
	Dividend Growth Model = D1/P0 + g,
	where D1 = the next dividend = D0*(1+g) and P0 = Price
	of the common share.
	Substituting values, we have cost of retained earnings =
	= 5.60*1.05/70+0.05 = 8.40%
	Cost new equity = D1/(P0-flotation cost per share) + g =
	= 5.60*1.05/(70-70*7%)+0.05 = 14.03%
2)	If Sholegg wants to retain its existing capital structure,
	the financing will be as follows:
	Debt = 55% = 300000*55% =	165000
	Retained earnings + New common equity = 45% = 300000*45% =	135000
	Total	300000
	Out of the equity, retained earnings will be	125000
	New common equity	10000
	So the capital structure would be:
	Debt	165000	55.00%
	Retained earnings	125000	41.67%
	New common equity	10000	3.33%
	Total	300000	100.00%
	Marginal cost of capital = 4.8*55%+9*41.67%+11.50*3.33% =	6.77%