Question

Eakins Inc.’s common stock currently sells for $53.00 per share, the company expects to earn $3.80 per share next year, its expected payout ratio is 70%, and its expected constant growth rate is 7.00%. New stock can be sold to the public at the current price, but a flotation cost of 10% would be incurred. By how much would the cost of new stock exceed the cost of retained earnings? Do not round your intermediate calculations.

Answer 1

Constant growth dividend discount model we need to use for this question:

Div1 = $3.80 * 70% = $2.66

For cost of retained earnings, since floatation cost would not come to play,

$53 = \frac{2.66}{r - 0.07}$

r = 12.0189% ---> Cost of Retained Earnings.

For cost of new stock issuance, floating cost would come to play.

Effective price, P0 = $53 * (1 - 10%) = $47.70

$47.70 = \frac{2.66}{r - 0.07}$

r = 12.5765% ---> Cost of New Equity Issuance

Cost of Equity difference = 0.5576% = 0.56%