Question

Common equity investors of Adventure Outfitter Corp. require a 15.6% return. The flotation costs of selling the stock amount to 5.5% of the selling price. The dividends are expected to grow at the 4.6% annual rate forever. Find the cost of new equity for the company, in %, to the nearest 0.01% (drop the % symbol when recording the answer).

Note: Use the alternative formula for finding the cost of new equity (on the instructor's handout; the formula in the text is incorrect).
Blank 1. Calculate the answer by read surrounding text.

This was all the information given.

Answer 1

Solution:-

Cost of equity= 15.6%

Using dividend discount model in case of constant growth rate, we have as follows:

Cost of equity= (D1/Po) + g

or,

Cost of equity= Dividend yield + growth rate

15.6%= Dividend yield + 4.6%

Dividend yield= 11%

Thus, let's say the stock price is $X. thus the dividend becomes 11% of $X or $0.11X. Now, if the floation cost of new issue is 5.5%, The cost of equity for the new shares is as follows:

Cost of equity= (D1/Po) + g = 0.11X/[X*(1-5.5%)] + 4.6% = (0.11X/0.945X) + 4.6% = 16.24%