Question

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?

Answer 1

Answer:

The cost of new stock exceed the cost of common from reinvested earnings by 0.38%

Explanation:

Hi, first we need to find the cost of the current stock, for that, we need to take into account that the dividend of this stock is EPS*(Payout Ratio), that is $2.75*0.7=$1.925. With that in mind, let´s find out what the cost of the current stock is.

$r=\frac{Dividend}{Price} +GrowthRate$

So, the cost of the current stock is:

$r=\frac{1.925}{45} +0.06=0.1027$

That is, 10.27%

Now, in order to find the cost of the new stock, we have to use the following formula.

$r_{new} =\frac{Dividend}{Price(1-Flotation)} +GrowthRate$

So, everything should look like this.

$r_{new} =\frac{1.925}{45(1-0.08)} +0.06=0.1065$

So, the cost of the new stock is 10.65%

Since the cost of the current stock is 10.27% and the new one is 10.65%, new stock exceed the cost of the current stock by 0.38%

Best of luck.