Question

KayCee paid a dividend yesterday of $3.50 per share. The dividend is expected to grow at a constant rate of 10% per year. The price of KayCee's common stock today is $40 per share. If KayCee decides to issue new common stock, flotation costs will equal $4.00 per share. KayCee's marginal tax rate is 35%. Based on the above information, the cost of new common stock is?

Answer 1

Dividend = D0 = $ 3..5 , Dividend Growth Rate = g = 10 %

Expected Dividend Next Year = D1 = 3.5 x 1.1 = $ 3.85

Current Stock Price = P0 = $ 40

Flotation Cost = $ 4 per share or 10 % of share price

Tax Rate = 35 %,

After-Tax Flotation Cost = (1-0.35) x 4 = $ 2.6

Flotation Cost % = 2.6 / 40 = 0.065 or 6.5 %

Let cost of equity be ke

Then, ke = [3.85 / {40 x (1-0.065)}] + 0.1 = 0.2029 or 20.29 %

NOTE: If flotation cost is not tax deductible, then flotation cost would continue to be 10 % of share price. In such a case ke = [3.85 / (40 x (1-0.1)] + 0.1 = 0.2069 or 20.69 %