Question

am’s Fine Garments sells jackets and sports coats in suburban malls throughout the country. Business has been good, as indicated by the ten-year growth in earnings per share. The earnings have grown from $1.00 to $3.10. (Use a Financial calculator to arrive at the answers.)

a. Determine the compound annual rate of growth in earnings (n = 10). Use Appendix A. (Round the final answer to 2 decimal places.)

Compound annual rate of growth             %

b. Based on the growth rate determined in part a, project earnings for next year (E₁). (Round compound annual rate of growth to 2 decimal places. Round the final answer to 2 decimal places.)

E₁           $

c. Assume the dividend payout ratio is 15 percent. Compute D₁. (Round intermediate calculations to 2 decimal places. Round the final answer to 2 decimal places.)

D₁           $

d. The current price of the stock is $11. Using the growth rate (g) from part a and D₁ from part c, compute K_e. (Round compound annual rate of growth to 2 decimal places. Round the final answer to 2 decimal places.)

K_e             %

e. If the flotation cost is $1.50, compute the cost of new common stock (K_n). (Round compound annual rate of growth to 2 decimal places. Round intermediate calculations to 2 decimal places. Round the final answer to 2 decimal places.)

K_n             %

Answer 1

a)

Compound annual rate of growth = (Future value / initial value)^1/n - 1

Compound annual rate of growth = (3.1 / 1)^1 / 10 - 1

Compound annual rate of growth = (3.1)^1/10 - 1

Compound annual rate of growth = 1.1198 - 1

Compound annual rate of growth = 0.1198 or 11.98%

b)

Next year earnings = Current year earnings (1 + growth rate)

Next year earnings = 3.1 (1 + 0.1198)

Next year earnings = $3.47

c)

D1 = Dividend payout ratio * next year earnings

D1 = (15 / 100) * 3.47

D1 = 0.52

d)

Ke = (Dividend in year 1 / price) + growth rate

Ke = (0.52 / 11) + 0.1198

Ke = 0.04727 + 0.1198

Ke = 0.1671 or 16.71%

e)

Price after flotation cost = 11 - 1.5 = 9.5

Cost of new common stock = (Dividend in year 1 / price) + growth rate

Cost of new common stock = (0.52 / 9.5) + 0.1198

Cost of new common stock = 0.1745 or 17.45%