Question

2). Raheem & Co Company has traced out an attractive project and because company is already highly leveraged, so CFO of the company want to increase the equity proportion in order to achieve the optimal capital structure. Common stock currently sells for Rs 100.00 per share, the company expects to pay Rs 10 dividend (D1) per share this year, and its expected constant growth rate is 5.0%. New stock can be sold to the public at the current price, but a flotation cost of 10% would be incurred.

1. Being the financial advisor of the company, trace out the difference between cost of new stock and cost of retained earnings. By how much would the cost of new stock exceed the cost of retained earnings?

2. Explain the major factors that affects WACC of any company. (1 Mark)

Answer 1

The cost of RE and new stock was found using the dividend discount model formula.

For retained earnings:

For new stock:

Formulas:

Common stock price	100
Dividend expected this year	10
Dividend growth rate	0.05
Flotation cost	0.1
Cost of retained earnings	=B3+B2/B1
Cost of new stock	=B3+B2/(B1*(1-B4))
Difference between cost of RE and new CE	=B7-B6

The WACC depends on

1. Cost of equity

2. Cost of preferred shares

3. Cost of Debt

4. Weight of equity

5. weight of preferred shares

6. weight of debt

7. Corporate Tax