Javits & Sons\' common stock currently trades at $34.00 a share. It is expected

Question

Javits & Sons' common stock currently trades at $34.00 a share. It is expected to pay an annual dividend of $1.75 a share at the end of the year (D1 = $1.75), and the constant growth rate is 5% 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 9% flotation cost. What would the cost of equity from new stock be? Round your answer to two decimal places.

Explanation / Answer

a) As per Dividend Discount Model,

The price of Common stock = Dividend / (r – g)

Where r = required rate of return

And g = growth rate in Dividend

Here g = 5%

Price of common stock = $34.00

Dividend = $1.75

As The price of Common stock = Dividend / (r – g)

=> $34.00 = $1.75 / (r - 0.05)

=> r – 0.05 = $1.75 / $34.00

=> r – 0.05 = 0.051471

=> r = 0.051471 + 0.05

=> r = 0.101471

=> r = 10.15%

So the company's cost of common equity if all of its equity comes from retained earnings = 10.15%

b) Floating cost = 9%

So new stock price = 34 X (1+0.09) = 37.06

As The price of Common stock = Dividend / (r – g)

=> $37.06 = $1.75 / (r - 0.05)

=> r – 0.05 = $1.75 / $37.06

=> r – 0.05 = 0.047221

=> r = 0.047221 + 0.05

=> r = 0.097221

=> r = 9.72%

The cost of equity from new stock = 9.72%

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