[rlsrapp]

I don’t understand why, in this problem, does the cost of retained earnings IGNORE flotation cost and underpricing?

Williams, Inc., is interested in measuring its overall cost of capital and has gathered the following data. Under the terms described as follows, the company can sell unlimited amounts of all instruments.
• Williams can raise cash by selling $1,000, 8%, 20-year bonds with annual interest payments. In selling the issue, an average premium of $30 per bond would be received, and the firm must pay flotation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8%.
• Williams can sell 8% preferred stock at par value, $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share.
• Williams’ common stock is currently selling for $100 per share. The firm expects to pay cash dividends of $7 per share next year, and the dividends are expected to remain constant. The stock will have to be underpriced by $3 per share, and flotation costs are expected to amount to $5 per share.
• Williams expects to have available $100,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing.
• Williams’ preferred capital structure is long-term debt, 30%; preferred stock, 20%; and common stock, 50%.
The cost of funds from retained earnings for Williams, Inc., is:
A.
7.0%.
B.
7.6%.
C.
7.4%.
D.
7.8%.

ANSWER IS A
The cost of retained earnings is 7.0%.
The cost of retained earnings, using the Gordon Model, ignores flotation costs and underpricing, since the firm does not need to issue new stock