Question

The McGonigall Company has just recently paid a dividend of $2.50 per share. Their dividends have been growing at a rate of 5% over the last several decades, and will most likely continue at that rate for the foreseeable future. Their stock is currently selling for $40.00 per share. If McGonigall were to issue new stock, they would incur flotation costs of 8%. What are the costs of internal equity and external equity for McGonigall? If the McGonigall company (from #4 above) has bonds with a 20-year maturity and a 6% coupon rate that are selling at a price of $920 (assume a $1,000 par value) what would be the before-tax cost of debt for the company. Also what would be the cost of equity using the bond-yield-plus-risk-premium approach if we assume that McGonigall is at the lower end of the risk premium range? How does this method of calculating the cost of equity compare with what you found in #4 above, and which estimate would you prefer to use and why?

Answer 1

cost of internal equity=D0*(1+g)/P+g=2.5*(1+5%)/40+5%=11.563%
cost of external equity==D0*(1+g)/(P*(1-f))+g=2.5*(1+5%)/(40*(1-8%))+5%=12.133%

Using financial calcultor,
assumign annual coupons
N=20
PMT=6%*1000=60
PV=-920
FV=1000
CPT I/Y=6.740%

Hence, pre-tax cost of debt=6.74%

cost of equity using the bond-yield-plus-risk-premium approach=6.74%+4%=10.74%

This approach yields lower cost of equity compared to above methods
We should choose above methods because bonds have different risk profile and justr adding risk premium on bond yield does not capture the full risk in equity