Question

Banyan Co.’s common stock currently sells for $37.75 per share. The growth rate is a constant 7%, and the company has an expected dividend yield of 4%. The expected long-run dividend payout ratio is 30%, and the expected return on equity (ROE) is 10.0%. New stock can be sold to the public at the current price, but a flotation cost of 10% would be incurred. What would be the cost of new equity? Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

The cost of new equity is calculated using the gordon growth model.

Ke= DI/ Po*(1 - F) + g

where:

Ke= cost of new equity

D1= dividend at the end of year 1

Po= current stock price

F= flotation cost

g= growth rate

Dividend at the end of year 1 is calculated first.

Dividend yield= D1/ Po

4% = D1/ $37.75

D1= 4%* $37.75

= $1.51

g= ROE*(1 - dividend payout ratio)

= 10%*(1 - 0.30)

= 10%*0.70

= 7%

Ke= $1.51/ $37.75*(1 - 0.10) + 7%

= $1.51/ $33.9750 + 7%

= 4.44 + 7%

= 11.44%

In case of any query, kindly comment on the solution.