Question

Hofstadler Inc.’s common stock currently trades at $105.25 per share. It is expected to pay an annual dividend of $4.50 at the end of the year, and the constant growth rate is 4.0% a year.  

a. What is the company’s cost of retained earnings (internal equity)? (5 points)
b. What is the company’s cost of new stock, if flotation costs are 5%? (5 points)

Answer 1

Solution:
	Cost of retained earnings (in %)	8.28	%
Working Notes:
	Cost of retained earnings means cost of shareholder fund which is already in the firm, so flotation cost is not required for internal cost , it is not part of issuance cost new equity shares.
Cost of Equity (Ke) = The return shareholders are expecting=cost of retained earnings=??
Using Gordon growth model : P0 = D1 / (Ke - g),
	ke = Cost of retained earnings=??
	Po=current share price = $105.25 per share
	g= growth rate= 4.0%
	D1= Expected Dividend at t=1= $4.50 per share
	P0 = D1/(Ke -g)
	Ke = (D1/P0) + g
	Ke = (4.50/105.25) + 4.0%
	Ke = 0.0427553 + 4.0%
	Ke=4.27553% + 4.0%
	Ke = 8.27553%
	Cost of retained earnings	8.28%
b.	Cost of new stock	8.50	%
Working Notes:
	Cost of new stock is the cost of equity new share which will be issued to raise fresh equity in the company , so it have to incurred flotation cost for issuance of new stock.
	Using Gordon growth model : P0 x (1-flotation cost) = D1 / (Ke - g),
	ke = Cost of new common stock =??
	Flotation cost F =5.00%
	Po=current share price = $105.25 per share
	g= growth rate= 4.0%
	D1= Expected Dividend at t=1=4.50
	P0 x (1-flotation cost) = D1 / (Ke - g),
	Ke = (D1/(P0 x (1-flotation cost))) + g
	Ke = (4.50/(105.25 x (1-0.05))) + 4.0%
	Ke = 0.045005626 + 4.0%
	Ke = 0.085005626
	Ke=8.50056%
	Ke = 8.50%
	Cost of new stock is 8.50%
Notes:	cost of new stock is higher than the cost of retained earnings as for cost of new stock have to incurred flotation cost also.
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