Trahern Baking Co.common stock sells for $32.50 per share.It expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, and its expected constant dividend growth rate is 6.0%.New stock can be sold to the public at the current price, but a flotation cost of 5% would be incurred.What would be the cost of equity from new common stock?
A) 12.70%
B) 13.37%
C) 14.04%
D) 14.74%
E) 15.48%

Question

Quizplus · Accepted Answer

The cost of equity from new common stock can be calculated using the dividend discount model (DDM) adjusted for flotation costs. The formula for the cost of equity (re) is: re = (D1 / P0(1 - F)) + g, where D1 is the dividend expected next year, P0 is the current price of the stock, F is the flotation cost as a decimal, and g is the growth rate. Given that the company expects to earn $3.50 per share and has a dividend payout ratio of 65%, the expected dividend (D0) is $3.50 * 0.65 = $2.275. The dividend expected next year (D1) would be $2.275 * (1 + 0.06) = $2.4115. The flotation cost is 5%, or 0.05 as a decimal. Therefore, re = ($2.4115 / ($32.50 * (1 - 0.05))) + 0.06 = 13.37%.