Question

Jarett & Sons's common stock currently trades at $27.00 a share. It is expected to pay an annual dividend of $1.00 a share at the end of the year (D1 = $1.00), and the constant growth rate is 8% a year. What is the company's cost of common equity if all of its equity comes from retained earnings? Round your answer to two decimal places. Do not round your intermediate calculations.

%

If the company issued new stock, it would incur a 9% flotation cost. What would be the cost of equity from new stock? Round your answer to two decimal places. Do not round your intermediate calculations.

%

Answer 1

Information provided:

Current stock price= $27

Next year’s dividend= $1

Growth rate= 8%

Flotation cost= 9%

The cost of equity is calculated using the dividend discount model. It is calculated using the below formula:

Ke=D1/Po+g

where:

D1= Next year’s dividend

Po=Current stock price

g=Firm’s growth rate

Ke= Cost of common equity

Ke= $1/ $27 + 0.08

     = 0.0370 + 0.08

     = 0.1170*100

     = 11.70%

Cost of new equity= D1/ Po*(1 – f) + g

Where:

D1= Next year’s dividend

Po= current stock price

f= flotation cost

g= growth rate

Cost of new equity= $1/ $27*(1 – 0.09) + 0.08

                                    = 0.0407 + 0.08

                                    = 0.1207*100

                                    = 12.07%.

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