Question

2.  Problem 10.04 (Cost of Equity with and without Flotation)

Jarett & Sons's common stock currently trades at $32.00 a share. It is expected to pay an annual dividend of $2.25 a share at the end of the year (D₁ = $2.25), and the constant growth rate is 7% a year.

1. What is the company's cost of common equity if all of its equity comes from retained earnings? Do not round intermediate calculations. Round your answer to two decimal places.

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2. If the company issued new stock, it would incur a 13% flotation cost. What would be the cost of equity from new stock? Do not round intermediate calculations. Round your answer to two decimal places.

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3.  Problem 10.05 (Project Selection)

Midwest Water Works estimates that its WACC is 10.43%. The company is considering the following capital budgeting projects.

Assume that each of these projects is just as risky as the firm's existing assets and that the firm may accept all the projects or only some of them. Which set of projects should be accepted?

Project	Size	Rate of Return
A	$1 million	12.0%	-Select-AcceptDon't acceptItem 1
B	2 million	11.5	-Select-AcceptDon't acceptItem 2
C	2 million	11.2	-Select-AcceptDon't acceptItem 3
D	2 million	11.0	-Select-AcceptDon't acceptItem 4
E	1 million	10.7	-Select-AcceptDon't acceptItem 5
F	1 million	10.3	-Select-AcceptDon't acceptItem 6
G	1 million	10.2	-Select-AcceptDon't acceptItem 7

Answer 1

2.a. The cost of common equity is computed as shown below:

= D1 / current stock price + growth rate

= $ 2.25 / $ 32 + 0.07

= 14.03% Approximately

2.b. The cost of common equity is computed as shown below:

= D1 / [ (current stock price) ( 1 - flotation cost) ] + growth rate

= $ 2.25 / [ ( $ 32 x ( 1 - 0.13) ] + 0.07

= 15.08% Approximately

3. The firm shall accept all those projects where the rate of return is greater than the WACC.

So, the projects that should be accepted will be:

Project A, B, C, D and E

Feel free to ask in case of any query relating to this question