Use the following information to answer the question below.
CDE Inc.'s current (and optimal) capital structure is 40% debt, 10% preferred stock, and 50% common equity. CDE is in the 40% tax bracket. The company can issue up to $20,000,000 in new bonds at par with a 7% coupon; any subsequent amount must carry a 2% premium to compensate investors for added risk. A new issue of preferred stock would pay an annual dividend of $4.00 and be priced to net the company $50.00 per share after the $3.00 per share floatation cost. The firm has $21,000,000 in retained earnings. CDE's common stock trades at $40.00 per share and the expected dividend on the common stock is 2.00. Floatation costs on common equity issues is $5.00 per share. The company is growing at 7% per year.
-What is the cost of internal common equity?
A) 5.0%
B) 9.0%
C) 12.0%
D) 7.0%

Question

Quizplus · Accepted Answer

The cost of internal common equity can be calculated using the Gordon Growth Model (also known as the Dividend Discount Model for a growing perpetuity), which is given by the formula: Cost of Equity = (D1 / P0) + g, where D1 is the dividend expected next year, P0 is the current price of the stock, and g is the growth rate. Here, D1 = $2.00 (given as the expected dividend), P0 = $40.00 (current stock price), and g = 7% or 0.07. Plugging these values into the formula gives: Cost of Equity = ($2.00 / $40.00) + 0.07 = 0.05 + 0.07 = 0.12 or 12%.

Use the Following Information to Answer the Question Below