Question

Barton Industries expects next year's annual dividend, D1, to be $2.40 and it expects dividends to grow at a constant rate g = 5%. The firm's current common stock price, P0, is $21.80. If it needs to issue new common stock, the firm will encounter a 5.3% flotation cost, F. Assume that the cost of equity calculated without the flotation adjustment is 12% and the cost of old common equity is 11.5%. What is the flotation cost adjustment that must be added to its cost of retained earnings? Round your answer to 2 decimal places. Do not round intermediate calculations.

2.What is the cost of new common equity considering the estimate made from the three estimation methodologies? Round your answer to 2 decimal places. Do not round intermediate calculations

Answer 1

Next year's dividend, D1 = 2.40

Dividednd growth, g = 5% or 0.05

Current stock price, p0 = 21.80

Flotation cost, f = 5.3% or 0.053

Cost of issuance of new equity, re = D1 / [p0 * ( 1 - f)] + g

Cost of issuance of new equity, re = 2.40 / [ 21.80 * ( 1 - 0.053)] + 0.05

Cost of issuance of new equity, re = (2.40 / 20.6446 ) + 0.05

Cost of issuance of new equity, re = 0.166253 or 16.6253%

So, flotation cost adjustment = 16.6253% - cost of equity calculated without the flotation

So, flotation cost adjustment = 16.6253% - 12%

flotation cost adjustment = 4.6253%

Cost of new common equity = old cost of equity + flotation adjustment

Cost of new common equity = 11.5% + 4.6253%

Cost of new common equity = 16.1253%

(Three methods to calculate cost of equity are Capital asset pricing method, Dividend discount model and bond yield plus risk premium)