Question

The difference between the flotation-adjusted cost of equity and the cost of equity calculated without the flotation adjustment represents the flotation cost adjustment.

Quantitative Problem: Barton Industries expects next year's annual dividend, D1, to be $2.20 and it expects dividends to grow at a constant rate g = 4.6%. The firm's current common stock price, P0, is $25.00. If it needs to issue new common stock, the firm will encounter a 6% flotation cost, F.

a. What is the flotation cost adjustment that must be added to its cost of retained earnings?

b. What is the cost of new common equity consider?

Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

a) To find the flotation adjustment, firstly calculate the implied required return on the new stock, using the dividend growth model:

Required return = next dividend / (price * (1 - flotation cost)) + dividend growth rate

required return = $2.20 / ($25.00 * (1 - 6%)) + 4.6%

required return = 13.9%

Now, cost of equity without flotation cost =

= ( $2.20 / $25.00 ) + 4.6% = 13.4%

The flotation adjustment cost = required return on new stocks - required return on equity without adjustment

= 13.9% - 13.4% = 0.5%

b) The cost of new common equity = cost of old common equity + flotation adjustment

Here in the question cost of old equity is missing so unable to answer this part