Zappin' Skeeters Corporation needs to know its cost of retained earnings. Based on the following information, compute the cost of retained earnings: The stock sells for $25, flotation costs are $3, and the firm is in the 35% tax bracket. $$\begin{array} { l l }
\text { Year } & \text { Dividend } \
2014 & \$ 1.55 \
2013 & \$ 1.40 \
2012 & \$ 1.35 \
2011 & \$ 1.32
\end{array}$$

Question

Zappin' Skeeters Corporation needs to know its cost of retained earnings. Based on the following information, compute the cost of retained earnings: The stock sells for $25, flotation costs are $3, and the firm is in the 35% tax bracket. $$\begin{array} { l l } 
\text { Year } & \text { Dividend } \
2014 & \$ 1.55 \
2013 & \$ 1.40 \
2012 & \$ 1.35 \
2011 & \$ 1.32
\end{array}$$

Quizplus · Accepted Answer

The cost of retained earnings can be calculated using the Gordon Growth Model (Dividend Discount Model). First, calculate the growth rate of dividends: $(1.55/1.32)^{1/3} - 1 = 0.0557$ or 5.57%. Then, use the formula: $$ \text{Cost of Retained Earnings} = \left(\frac{\text{Dividend per share next year}}{\text{Current stock price - Flotation costs}}\right) + \text{Growth rate} $$ $$ = \left(\frac{1.55 \times 1.0557}{25}\right) + 0.0557 = 0.1256 $$ or 12.56%.