Eakins Inc.'s common stock currently sells for $45.00 per share,the company expects to earn $2.75 per share during the current year,its expected payout ratio is 70%,and its expected constant growth rate is 6.00%.New stock can be sold to the public at the current price,but a flotation cost of 8% would be incurred.By how much would the cost of new stock exceed the cost of retained earnings?

Question

Quizplus · Accepted Answer

First, we need to calculate the cost of retained earnings:
Cost of Retained Earnings = (D1 / P0) + g
where: 
D1 = expected dividend per share next year = expected earnings * payout ratio = 2.75 * 0.70 = 1.925
P0 = current market price per share = $45.00
g = expected constant growth rate = 6.00%
Cost of Retained Earnings = (1.925 / 45.00) + 0.06 = 0.1038 or 10.38%

Next, we need to calculate the cost of new stock:
Cost of New Stock = (D1 / (P0*(1-F))) + g
where:
F = flotation cost = 8%
Cost of New Stock = (1.925 / (45.00*(1-0.08))) + 0.06 = 0.1418 or 14.18%

Finally, we can find the difference between the two costs:
Difference = Cost of New Stock - Cost of Retained Earnings = 14.18% - 10.38% = 3.8%

Therefore, the cost of new stock exceeds the cost of retained earnings by 3.8%, or 0.37% (rounded to two decimal places). The best choice is C.