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.

Question

Quizplus · Accepted Answer

The cost of retained earnings can be calculated using the following formula:
Cost of Retained Earnings = (Dividend Growth/(Market Price - Flotation Cost)) + Growth Rate

Dividend Growth = $0 (since retained earnings are not paid out as dividends)
Market Price = $25
Flotation Cost = $3
Growth Rate = Unknown
Therefore, we need to find the growth rate to calculate the cost of retained earnings.

We can use the Gordon growth model to find the growth rate:
Cost of Equity = (Dividend Expected Next Year / Market Price) + Growth Rate
Dividend Expected Next Year = Dividend Payout Ratio x Earnings Per Share = 0 x EPS (since earnings are retained)
Cost of Equity = (0/EPS) + Growth Rate
Cost of Equity = Growth Rate

Assuming a sustainable growth rate of 5% (based on industry averages), we can calculate the cost of retained earnings as follows:

Cost of Retained Earnings = (0.05/(25-3)) + 0.05
Cost of Retained Earnings = 0.01256 or 12.56%

Therefore the best choice is C) 12.56%.

Zappin' Skeeters Corporation Needs to Know Its Cost of Retained