Question

5. The cost of new common stock True or False: The following statement accurately describes how firms make decisions related to issuing new common stock. If a firm needs additional capital from equity sources once its retained earnings breakpoint is reached, it will have to raise the capital by issuing new common stock. False: Firms raise capital from retained earnings only when they cannot issue new common stock due to market conditions outside of their control. True: Firms will raise all the equity they can from retained earnings before issuing new common stock, because capital from retained earnings is cheaper than capital raised from issuing new common stock. White Lion Homebuilders is considering investing in a one-year project that requires an initial investment of $500,000. To do so, it will have to issue new common stock and will incur a flotation cost of 2.00%. At the end of the year, the project is expected to produce a cash inflow of $550,000. The rate of return that White Lion expects to earn on its project (net of its flotation costs) is (rounded to two decimal places). Alpha Moose Transporters has a current stock price of $22.35 per share, and is expected to pay a per-share dividend of $2.03 at the end of the year. The company’s earnings’ and dividends’ growth rate are expected to grow at the constant rate of 8.70% into the foreseeable future. If Alpha Moose expects to incur flotation costs of 6.50% of the value of its newly-raised equity funds, then the flotation-adjusted (net) cost of its new common stock (rounded to two decimal places) should be . White Lion Homebuilders Co.’s addition to earnings for this year is expected to be $420,000. Its target capital structure consists of 50% debt, 5% preferred, and 45% equity. Determine White Lion Homebuilders’s retained earnings breakpoint: $886,666 $1,026,666 $1,166,666 $933,333

Answer 1

The answer is

True: Firms will raise all the equity they can from retained earnings before issuing new common stock, because capital from retained earnings is cheaper than capital raised from issuing new common stock.

Rate of Return = Inflows/(Investment+Flotation cost)

= [550,000-500,000/98%]/(500,000/98%)

= 7.80%

Stock Price(1-flotation cost)= Expected Dividend/(Cost of Equity – growth rate)

22.35(1-6.50%) = 2.03/(Cost-8.70%)

Cost of Equity = 18.4142%

i.e. 18.41%

Retained earnings break point = Earnings/Share of Equity

= 420,000/45%

= $933,333