Question

Sentry Manufacturing paid a dividend yesterday of $5 per share. The dividend is expected to grow at a constant rate of 8% per year. The price of Sentry Manufacturing's stock today is $29 per Jure. If Sentry Manufacturing decides to issue new common stock, flotation costs will equal $2.50 per share. Sentry Manufacturing s marginal tax rate is 35%. Based on the above information, the cost of new common stock is 28.38%. 24.12%. 26.62%. 31.40%.

Answer 1

The cost of new common stock can be calculated using the Dividend Growth Model:

Cost of New Common Stock = (Dividend / Stock Price) + Growth Rate

The dividend is given as $5 per share, and the stock price is $29. The growth rate is 8%.

Cost of New Common Stock = (5 / 29) + 8% = 0.1724 + 0.08 = 0.2524 = 25.24%

However, we need to consider the flotation costs and the tax rate.

Flotation costs are $2.50 per share, so the effective price after flotation costs is $29 + $2.50 = $31.50.

After-tax flotation costs = Flotation costs * (1 - Tax rate) = $2.50 * (1 - 0.35) = $1.625

Cost of New Common Stock = (Dividend / (Stock Price - After-tax Flotation costs)) + Growth Rate

Cost of New Common Stock = (5 / (31.50 - 1.625)) + 8% = 0.1731 + 0.08 = 0.2531 = 25.31%

Therefore, the cost of new common stock is 25.31%, which is closest to 24.12% in the given answer choices.