Here is the explanation:
Newmass, Inc., paid a cash dividend to its common shareholders over the past 12 months of $2.20 per share. The current market value of the common stock is $40 per share and investors are anticipating the common dividend to grow at a rate of 6% annually. The costs to issue new common stock will be 5% of the market value. The cost of a new common stock issue will be:
A.
11.50%.
B.
11.79%.
C.
11.83%.
Correct D.
12.13%.
You are correct, the answer is D.
Use the Gordon Growth Model on this one, and remember that it is the next dividend that is used. In this case, this year's dividend will be 6% greater than last year's $2.20, or $2.33. In the formula, capital cost equals dividend/net proceeds of stock sale plus growth rate.
Dividend
Ks =
+ G
Price (1-flotation)
Here Ks = 2.33/[40(1-.05)] + .06
= 2.33/38 + .06 = 12.13
The cost of equity using the Gordon Growth Models equals the quotient of the next dividend divided by the stock price, plus the growth rate in earnings per share. To account for flotation costs, the stock price is multiplied by one minus the flotation cost. Given that the next dividend is $2.332 (1.06 × $2.20), the cost of the new common stock is 12.13% ([2.332 ÷ ($40 × (1 -.05))] + .06).
.