The management of Old Fenske Company (OFC has been reviewing the company’s financing arrangements. The current financing mix is $750,000 of common sto... Accounting MCQs | Accounting MCQs

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

9.5%
14.2%
15.8%
16.0%Show Result

Correct - Your answer is correct.

Wrong - Your answer is wrong.

Detailed Answer

Answer (C) is correct. The cost of new common stock is the next dividend ($2.20) divided by the net proceeds of the stock. If this were to involve a new sale of stock, the flotation costs would be deducted from the selling price to get the net proceeds. However, this was for retained earnings, so there is no deduction. The calculation is to divide the $2.20 dividend by the $38 selling price to get 5.8%. Add the 10% growth rate and the answer is 15.8%.