Question

The Evanec Company's next expected dividend, D1, is $3.95; its growth rate is 4%; and its common stock now sells for $37.00. New stock (external equity) can be sold to net $31.45 per share.
What is Evanec's cost of retained earnings, rs? Do not round intermediate calculations. Round your answer to two decimal places.
What is Evanec's percentage flotation cost, F? Round your answer to two decimal places.
What is Evanec's cost of new common stock, re? Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

Answer:

rs=14.68%

F=15%

re=16.56%

Explanation:

using the constant growth model:

$P0=\frac{D1}{rs-g}$

where P0 is the current stock price

           D1 is the dividend expected at the end of the 1st year

            rs is  cost of retained earnings.

Rearranging to make rs subject of the formula:

$rs=\frac{D1}{P0}+ g$

$rs=\frac{3.95}{37}+ 0.04 = 0.1468$

if Evanec issues new stock, they will only net $31.45 down from $37 per share due to floatation costs. The difference, ie  $37-$31.45 = $5.55 is due to floation costs.

The percentage floatation costs (F) are $\frac{5.55}{37} = 0.15 = 15%$

alternatively, one can recognise that  $37(1-F)=31.45$  and F = 15%

Cost of new common stock re is calculated as follows:

$re=\frac{D1}{P0(1-F)}+ g$

$re=\frac{3.95}{37(1-0.15)}+ 0.04 = 0.1656 = 16.56%$