Sentry Manufacturing paid a dividend yesterday of $5 per share (D₀= $4).The dividend is expected to grow at a constant rate of 8% per year.The price of Sentry Manufacturing's stock today is $29 per share.If Sentry Manufacturing decides to issue new common stock,flotation costs will equal $2.50 per share.Sentry Manufacturing's marginal tax rate is 35%.Based on the above information,the cost of retained earnings is

Question

Quizplus · Accepted Answer

Using the Gordon model, we can calculate the cost of equity:

rE = (D1/P0) + g

where:
D1 = expected dividend next year = $5 x (1+8%) = $5.40
P0 = current market price = $29
g = growth rate = 8%

rE = ($5.40/$29) + 8% = 26.62%

Note that the flotation costs and tax rate are not used in the calculation of the cost of retained earnings. Only the expected dividend and growth rate are relevant.

Sentry Manufacturing Paid a Dividend Yesterday of $5 Per Share