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A firm has determined its optimal structure which is composed of the following sources and target market value proportions.

Debt: The firm can sell a 15-year, $1,000 par value, 8 percent bond for $1,050. A flotation cost of 2 percent of the face value would be required in addition to the premium of $50.
Common Stock: A firm's common stock is currently selling for $75 per share. The dividend expected to be paid at the end of the coming year is $5. Its dividend payments have been growing at a constant rate for the last five years. Five years ago, the dividend was $3.10. It is expected that to sell, a new common stock issue must be underpriced $2 per share and the firm must pay $1 per share in flotation costs. Additionally, the firm has a marginal tax rate of 40 percent.


The firm's cost of retained earnings is ________. (See Table 9.2)

Question 15 options:

I am having a hard time figuring out the annual dividend gain on common stock so I can finish answering the question.

a) 10.2 percent b) 14.3 percent c) 16.7 percent d) 17.0 percent

Explanation / Answer

Growth rate = (Expected Dividend/Dividend 5 year ago)^(1/5) - 1

Growth rate = (5/3.1)^(1/5) -1

Growth rate = 10.03%

Firm's cost of retained earnings = Expected Dividend/Current Share Price + growth rate

Firm's cost of retained earnings = 5/75 + 10.03%

Firm's cost of retained earnings = 16.70%

Answer

c) 16.70%

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