1. A company just paid a $2.00 per share dividend on its common stock (D 0 = $2.
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Question
1. A company just paid a $2.00 per share dividend on its common stock (D0 = $2.00). The dividend is expected to grow at a constant rate of 7 percent per year. The stock currently sells for $42 a share. If the company issues additional stock, it must pay its investment banker a flotation cost of $1.00 per share. What is the cost of external equity, ke?
2. Allison Engines Corporation has established a target capital structure of 40% debt and 60% common equity. The current market price of the firms stock is Po = $28; its last divident was Do = $2.20, and its expected dividend growth is 6 percent. What will Allison's marginal cost of retained earnings, Rs, be?
Explanation / Answer
Dividend Growth Model formula
Cost of Equity (Ke) = [D1 / (P0 – Flotation cost)] + Growth rate
Where D1 = D0 (1+growth rate) = $2 (1+0.07) = $2.14
P0 = $42 per share
Flotation Cost = $1 per share
Growth rate = 7%
Cost of Equity (Ke) = [$2.14 / ($42 - $1)] + 7%
Cost of Equity (Ke) = 0.0522 + 0.07
Cost of Equity (Ke) = 12.22% or 0.1222
Cost of retained earnings (ks) is the return stockholders require on the company's common stock.
Dividend Growth Model formula
Cost of Equity (Ke) = [D1 / P0] + Growth rate
Where D1 = D0 (1+growth rate) = $2.20 (1+0.06) = $2.332
P0 = $28 per share
Growth rate = 6%
Cost of Equity (Ke) = [$2.332 / $28] + 6/%
Cost of Equity (Ke) = 0.0833 + 0.06
Cost of Equity (Ke) = 14.33% or 0.1433
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