Question

The Cost of Equity and Flotation Costs Messman Manufacturing will issue common stock to the public for $30. The expected dividend and the growth in dividends are $2.00 per share and 5%, respectively. If the flotation cost is 11% of the issue's gross proceeds, what is the cost of external equity, re? Round your answer to two decimal places.

Answer 1

Solution :

The following formula is used to calculate cost of external equity :

r_e = [ D₁ / (P *( 1 – F )) ] + g

Where,

r_e = Cost of external equity
D₁ = Expected dividend
P = Issue price of common stock
F = Flotation cost as a percentage of the issue’s gross proceeds
g = Growth rate of dividend

As per the information given in the question we have

D₁ = Expected dividend = $ 2.00
P = Issue price of common stock = $ 30
F = Flotation cost as a percentage of the issue’s gross proceeds = 11 % = 0.11
g = Growth rate of dividend = 5 % = 0.05

Applying the above values in the formula we have

= [ 2 / ( 30 * ( 1 – 0.11 ) ) ] + 0.05

= [ 2 / ( 30 * ( 0.89 ) ) ] + 0.05

= [ 2 / 26.7 ] + 0.05

= 0.0749 + 0.05 = 0.1249

= 12.49 %

Thus the external cost of equity is = 12.49 % ( when rounded off to one decimal places )

= 12.5 % ( when rounded off to one decimal place )