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The management of Old Fenske Company (OFC) has been reviewing the company's financing arrangements. The current financing mix is $750,000 of common stock, $200,000 of preferred stock ($50 par) and $300,000 of debt. OFC currently pays a common stock cash dividend of $2. The common stock sells for $38, and dividends have been growing at about 10% per year. Debt currently provides a yield to maturity to the investor of 12% and preferred stock pays a dividend of 9% to yield 11%. Any new issue of securities will have a flotation cost of approximately 3%. OFC has retained earnings available for the equity requirement. The company's effective income tax rate is 40%. Based on this information, the cost of capital for retained earnings is:
1- 9.5 %
2- 14.2%
3- 15.8%
4- 16.0%
I am using exammatrix software for CMA part 3 and the correct answer to this question was # 4 While as it was solved by exammatrix as following:
Cost of capital = (Dividend per share ÷ (Market value per share - Flotation cost per share)) + Dividend growth rate•(($2 × 1.1) ÷ ($38 × .97)) + .10 = .1596 (16.0%)
I am thinking that the correct answer was supposed to be # 3 because retain earning has nothing to do with issuing securities cost.
What do you think I need your openion here
Comments
dear Mr. Rashid
i have another idea for this question
In my opinion the answer is 15.8% namber (3)
reason why ..
becouse in RE we dont calculate any cost of issue , couse RE only have one cost it is the opportunity cost other wise the qustion didnt say any think about opportunity so we have to calculated it in this way
2.2 ÷ 38 + .1 = .15789 = 15.8
2.2 from 2 * .1 = 2.2
if you have any comments please share
thanks
Hi Hazim
excactly #3 is supposed to be the correct answer I agree with you because RE has nothing to do with issuing cost.
in the question above the answer # 4 was supposed to be for the cost of financing by common stock not RE.
I'm also in agreement, because the company is retaining the money, it has nothing to do with flotation costs. Thats obviously one of the benifits of retaining the money in the company as opposed to issuing new C.S. better call exam matrix and ask for you money back.. (JK)..
From the question: "Any new issue of securities will have a floatation cost of approximately 3%. OFC has retained earnings available for the equity requirement."
I believe OFC is planning to use the retained earnings to issue new securities, and so the floatation cost.
Hi Sumaya
Well I dont think so because the only cost that related to RE is apportunity cost
An additional resource for you would be the Q&A Group Forum within the Global Study Group. You may want to check this out.
Yes I also agree with the point, issue cost is irrelevant when calculating cost of retained earnings. The cost of retained earnings is usually lower than the cost of equity, due to issue costs and taxes associated with fresh issue.