Cost of Retained Earnings

Explanation

EBIT$1,000,000 -

Interest400,000 -

EBT$600,000 -

Taxes (40%)240,000 -

Net income$360,000 -

EPS(1) = $360,000/100,000 = $3.60.

D(1) = $3.60(0.5)= $1.80.

k(s) = ($1.80/$40.00) + 0.125 = 17.0%.

To calculate the cost of retained earnings, we need to use the Gordon growth model, also known as the dividend discount model (DDM).

The formula for the Gordon growth model is as follows: Cost of Retained Earnings (k) = (Dividends per Share / Current Stock Price) + Growth Rate

Let's break down the information given in the question to calculate the cost of retained earnings step by step:

1. Earnings before interest and taxes (EBIT) for the coming year is $1,000,000.

2. The earnings and dividends are expected to grow indefinitely at a constant annual rate of 12.5 percent. This growth rate is denoted as "g."

3. The firm has $5,000,000 of debt outstanding with a coupon interest rate of 8 percent. Since we are calculating the cost of retained earnings, we do not need this information.

4. The firm has 100,000 shares of common stock outstanding.

5. Historically, Becker has paid 50 percent of net earnings to common shareholders in the form of dividends. Since we want to calculate the cost of retained earnings, we need to adjust the dividend payout ratio to reflect the retained earnings ratio. The retained earnings ratio is 1 minus the dividend payout ratio. Therefore, the retained earnings ratio is 1 - 0.5 = 0.5.

6. The current price of Becker's common stock is $40.

7. It would incur a 10 percent flotation cost if it were to sell new stock. Since we want to calculate the cost of retained earnings, we do not need this information.

8. The firm's tax rate is 40 percent. We do not need this information for calculating the cost of retained earnings.