Question

Banyan Co.’s common stock currently sells for $46.25 per share. The growth rate is a constant 10.8%, and the company has an expected dividend yield of 3%. The expected long-run dividend payout ratio is 40%, and the expected return on equity (ROE) is 18%. New stock can be sold to the public at the current price, but a flotation cost of 15% would be incurred. What would be the cost of new equity? Round your answer to two decimal places. Do not round your intermediate calculations.

Answer 1

Calculate the growth rate as follows:

Growth rate = ROE * Retention ratio

Growth rate = 18% *(1-40%)

Growth rate = 10.80%

Note: Retention ratio = 1- dividend payout ratio

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Calculate the expected Dividend as follows:

Dividend yield = Expected dividend / Current price

3% = Expected dividend / $46.25

Expected dividend = $1.3875

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Calculate the cost of new equity as follows:

Cost of new equity = (expected dividend / ((Current price*(1-Flotation cost))) + Growth rate

Cost of new equity = ($1.3875 / ($46.25*(1-15%))) + 10.80%

Cost of new equity = 14.34%

Therefore, the cost of new equity is 14.34%.