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Cost of retained earnings, new common stock and debt

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The management of a conservative firm has adopted a policy of never letting debt exceed 30 percent of total financing. The firm will earn $10,000,000 but distribute 40 percent in dividends, so the firm will have $6,000,000 to add to retained earnings. Currently the price of the stock is $50, the company pays a $2 per share dividend, which is expected to grow annually at 10 percent. If the company sells new shares, the net to the company will be $48. Given this information, what is the

a) cost of retained earnings?

b) cost of new common stock?

The rate of interest on the firm's long-term debt is 10 percent and the firm is in the 32 percent income tax bracket. If the firm issues more than $2,400,000, the interest rate will rise to 11 percent. Given this information, what is the

c) cost of debt;

d) cost of debt in excess of $2,400,000?

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Solution Summary

The expert examines the cost of retained earnings, new common stock and debt.

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Cost of debt = interest rate x (1-tax rate)

d. Cost of debt = 0.11 x (1-0.32) = 0.075 = 7.5%

c. Cost of debt = 0.10 x (1-0.32) = 0.068 = 6.8%

Cost of new common stock = ...

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