The Global Advertising Company had net income after interest but before taxes of $40,000 this year. The marginal tax rate is 40 percent, and the dividend payout ratio is 30 percent. The company can raise debt at a 12 percent interest rate. The last dividend paid by Global was $0.90. Global's common stock is selling for
$8.59 per share, and its expected growth rate in earnings and dividends is 5 percent. If Global issues new common stock, the flotation cost incurred will be 10 percent. Global plans to finance all capital expenditures with 30 percent debt and 70 percent equity. What is Global's cost of retained earnings?
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k(s) (component cost of retained earnings) = $.945/$8.59 + 0.05 = 0.1600 = 16.00%.
To calculate the cost of retained earnings for Global Advertising Company, we need to consider the components involved in the calculation.
Dividend Payout Ratio: The dividend payout ratio is the proportion of net income after interest but before taxes that is distributed as dividends. In this case, the dividend payout ratio is given as 30%. This means that 30% of the net income will be paid out as dividends, while the remaining 70% will be retained by the company for reinvestment.
Retention Ratio: The retention ratio is the complement of the dividend payout ratio and represents the proportion of earnings that are retained by the company. In this case, the retention ratio is 70% (100% - 30%).
Cost of New Equity: To calculate the cost of retained earnings, we need to consider the cost of new equity. This is the cost incurred when the company issues new common stock.
The cost of new equity can be calculated using the dividend growth model, which is based on the assumption that the cost of equity is equal to the dividend yield plus the expected growth rate in dividends.
The dividend yield can be calculated as the dividend per share divided by the stock price. In this case, the last dividend paid was $0.90, and the stock price is $8.59 per share. Therefore, the dividend yield is (0.90 / 8.59) = 0.1047, or 10.47%.
The expected growth rate in earnings and dividends is given as 5%.
Using these values, we can calculate the cost of new equity: Cost of New Equity = Dividend Yield + Growth Rate Cost of New Equity = 10.47% + 5% Cost of New Equity = 15.47%
Flotation Cost: The flotation cost is the cost incurred by the company when issuing new common stock. In this case, the flotation cost is given as 10%.
Cost of Retained Earnings: The cost of retained earnings is the return required by the shareholders on the retained earnings. It is calculated as the cost of new equity adjusted for the flotation cost.
Cost of Retained Earnings = Cost of New Equity * (1 - Flotation Cost) Cost of Retained Earnings = 15.47% * (1 - 10%) Cost of Retained Earnings = 15.47% * 0.9 Cost of Retained Earnings = 13.92%
Therefore, the cost of retained earnings for Global Advertising Company is approximately 13.92%.
None of the provided answer choices match the calculated value.