Question

Banyan Co.’s common stock currently sells for $54.50 per share. The growth rate is a constant 10.5%, and the company has an expected dividend yield of 6%. The expected long-run dividend payout ratio is 25%, and the expected return on equity (ROE) is 14%. New stock can be sold to the public at the current price, but a flotation cost of 5% would be incurred. What would be the cost of new equity? Round your answer to two decimal places. Do not round your intermediate calculations.

Answer 1

We can get the cost of common equity in this case from dividend discount model.

Which is :-

R_e = D₁/P₀(1-f) + g

Where R_e = Cost of common equity

P₀ = Current market price of the share

D₁ = Dividends to be paid in the next period

g = Growth rate

F = Floatation cost

Now,

P_{0 =} $54.50

D₀ = $54.50 * 6% = $3.27

D₁ = D₀(1+g) = 3.27(1+0.105) = 3.61335

g = 10.5%

F = 5%

Putting the following values in the formula, we get.

R_e = 3.61335/54.50(1-0.05) + 0.105

    = 3.61335/51.775 + 0.105

    = 0.0697894737 + 0.105 = 0.174789474 or 17.48%

So the cost of common equity is 17.48%.