As the winner of a contest, you are now CFO for the day for Maguire Inc.and your day's job involves raising capital for expansion.Maguire'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 common from reinvested earnings?
A) 0.09%
B) 0.19%
C) 0.37%
D) 0.56%
E) 0.84%

Question

Quizplus · Accepted Answer

To calculate the cost of new stock, we need to first find the cost of equity using the dividend growth model:

Cost of equity = (Next year's expected dividend / Current stock price) + expected growth rate
Next year's expected dividend = Expected earnings per share x payout ratio
Next year's expected dividend = $2.75 x 70% = $1.925
Cost of equity = ($1.925 / $45) + 6% = 10.28%

To account for the flotation cost, we need to adjust the cost of equity:

Adjusted cost of equity = Cost of equity / (1 - Flotation cost percentage)
Adjusted cost of equity = 10.28% / (1 - 8%) = 11.15%

Now, we need to calculate the cost of common equity from reinvested earnings, which is the cost of equity if the company were to retain all earnings and reinvest them in the company without issuing new equity:

Cost of common equity from reinvested earnings = (Next year's expected dividend / Current stock price) + expected growth rate
Next year's expected dividend = Expected earnings per share x (1 - payout ratio)
Next year's expected dividend = $2.75 x 30% = $0.825
Cost of common equity from reinvested earnings = ($0.825 / $45) + 6% = 8.30%

The difference between the cost of new stock and the cost of common equity from reinvested earnings is:

Difference = Adjusted cost of equity - Cost of common equity from reinvested earnings
Difference = 11.15% - 8.30% = 2.85%

Finally, we need to express the difference as a percentage of the cost of common equity from reinvested earnings:

Percentage difference = Difference / Cost of common equity from reinvested earnings
Percentage difference = 2.85% / 8.30% = 0.3434, or 0.37% rounded to the nearest hundredth.

Therefore, the cost of new stock would exceed the cost of common equity from reinvested earnings by 0.37%. The best choice is C.

As the Winner of a Contest, You Are Now CFO