6. Reynolds Textiles wants to measure its cost of common equity. The firm’s stoc

Question

6. Reynolds Textiles wants to measure its cost of common equity. The firm’s stock is currently selling for $57.50 per share. The firm expects to pay a $3.40 dividend at the end of 2011 (so assume that
D1 = $3.40 for purposes of calculation). The dividends for the last 5 years are as follows:

Year Dividend

2010 $3.10
2009 $2.92
2008 $2.60
2007 $2.30
2006 $2.12

After incurring flotation costs, Reynolds Textiles expects to net $52 per share on a new issue.
(a) Determine the growth rate of dividends (g).
(b) By applying the constant-growth valuation model, determine the cost of retained earnings common equity (rs).
(c) By applying the constant-growth valuation model, determine the cost of newly-issued common equity (re).

Explanation / Answer

(a) Growth rate of dividend: D1 = D0(1+g)^1 Here D1 is $3.40. then D0 is $3.10 $3.40 = $3.10(1+g) (1+g) = 3.40/3.10 = 1.0967 g = 0.0967 Growth rate is 9.67%. Therefore dividend growth rate is 9.67%. (b) Cost of retained earnings common equity = Dividend/Mareket price + growth rate = 3.40/57.50 + 9.67% = 0.0591 + 9.67% = 5.91% + 9.67% = 15.58% Cost of retained earings common equity is 15.58%. (c) Newly issued common equity = Dividend/Net proceeds + Growth rate = 3.40/52 + 9.67% = 0.065 + 9.67% = 6.5% + 9.67% = 16.67% Cost of newly issued common equity is 16.67%

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