Javits & Sons\' common stock currently trades at $39.00 a share. It is expected

Question

Javits & Sons' common stock currently trades at $39.00 a share. It is expected to pay an annual dividend of $3.00 a share at the end of the year (D1 = $3.00), and the constant growth rate is 7% 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.
%

If the company were to issue new stock, it would incur a 19% flotation cost. What would the cost of equity from new stock be? Round your answer to two decimal places.

Explanation / Answer

Formula: current price of equity share = D1/(rate of return - growth rate)

39 = 3/(r - 0.07)

3/39 = r - 0.07

r = 0.076923+0.07 = 14.69%. This is the cost of common equity if all equity comes from retained earnings as retained earnings have an opportunity cost.

effective price of new stock = price *(1-flotation cost)

= 39*(1-0.19) = 39*0.81 = 31.59

so, using the formula:

31.59 = 3/(r - 0.07)

3/31.59 = r - 0.07

r = 0.1650 or 16.50%. This is the cost of equity from new stock.

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