Martin Corporation's common stock is currently selling for $50 per share. The current dividend is $2.00 per share. If dividends are expected to grow at 6 percent per year and if flotation costs are 10 percent, then what is the firm's cost of retained earnings and what is its cost of new common stock?
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A. B. C. D. E.B
Cost of retained earnings:
k(s) = $2.12/$50 + 0.06 = 10.24%.
Cost of new common equity:
k(e) = $2.12/($50(1-.10)) + 0.06 = 10.71%.
To calculate the cost of retained earnings and the cost of new common stock, we need to use the dividend growth model and take into account the flotation costs.
The dividend growth model can be used to calculate the cost of retained earnings, which is expressed as:
Cost of Retained Earnings = (Dividends per Share / Current Stock Price) + Growth Rate of Dividends
In this case: Dividends per Share = $2.00 Current Stock Price = $50.00 Growth Rate of Dividends = 6% = 0.06
Cost of Retained Earnings = ($2.00 / $50.00) + 0.06 = 0.04 + 0.06 = 0.10 or 10%
Therefore, the cost of retained earnings is 10%.
The cost of new common stock can be calculated using the following formula:
Cost of New Common Stock = (Dividends per Share / (Current Stock Price - Flotation Costs)) + Growth Rate of Dividends
In this case: Dividends per Share = $2.00 Current Stock Price = $50.00 Flotation Costs = 10% of Current Stock Price = 0.10 * $50.00 = $5.00 Growth Rate of Dividends = 6% = 0.06
Cost of New Common Stock = ($2.00 / ($50.00 - $5.00)) + 0.06 = $2.00 / $45.00 + 0.06 = 0.0444 + 0.06 = 0.1044 or 10.44%
Therefore, the cost of new common stock is 10.44%.
The correct answer is option D: 10.24% for the cost of retained earnings and 11.38% for the cost of new common stock.