Question

“BLACKFRIDAY” company is planning an expansion of its existing production capacity. The firm hired you as a consultant for the expansion project. Since you are a savvy project manager, you first decided to estimate the firm’s cost of capital based on the available data.

Data:

• Tax Rate: 40%
• Bond: Coupon rate 12%, Maturity Years 15, Present value $1150
• Preferred Stock: Dividend rate 10%, Par Value $100, Present Value $111 Common Stock: Market price $50, D₀=$4.20, Dividend growth 5%, Beta 1.2, Treasury Bond yield 7%, Market risk premium 6%. When the firm uses Bond-yield+Premium method, the risk premium is 4%.
• Capital structure of ABC is as follows;
  • Debt 30%, Common Equity 60%, Preferred Stock 10%

Next, you asked your assistant “Mr.COUPON” to give his opinion on the following burning questions;

1. What is your final Cost of Equity?
2. Do you agree that the cost of new equity is cheaper than the cost of retained earnings? Why?
3. What is flotation cost and how do you adjust it?
4. If the flotation cost of new stock issue is 10%, what is the estimated cost of equity considering the 10% flotation cost under DCF method you calculated in question iv above? (cost of equity using discounted cashflow technique is 15.50%)

Answer 1

i). Cost of debt: PV = 1,150; FV = 1,000; PMT (annual coupon) = coupon rate*FV = 12%*1,000 = 120; n = 15, solve for RATE.

YTM = 10.03% (Note: Question does not specify whether the bond is annual or semi-annual, so annual has been assumed.)

Cost of equity (using bond + premium) = cost of bond + additional risk premium = 10.03% + 4% = 14.03%

Cost of equity (using CAPM) = risk-free rate + beta*market risk premium

= 7% + 1.2*6% = 14.20%

Cost of equity (using DDM) = (D1/P0) + g = (D0*(1+g)/P0) + g = (4.20*(1+5%)/50) + 5% = 13.82%

We have three different costs of equity now. It is usually decided at the discretion of the analyst depending upon company and market specifics. In this case, we will take an average of all three, as the final cost of equity.

Final cost of equity = (14.03% + 14.20% + 13.82%)/3 = 14.02%

ii). No, the cost of new equity is higher than the cost of retained earnings due to flotation costs incurred during a new stock issue.

iii). Flotation costs are costs incurred when new securities are issued and sold.They consist of underwriting costs and administrative costs. They are usually charged as a percentage or a fixed number of the price at which the security is issued. The price is therefore, adjusted by that amount.

iv). Cost of equity using DDM is 13.82% (not 15.50%)

If 10% flotation cost is charged then cost will be (D0*(1+g)/P0*(1-10%)) + g

= (4.20*(1+5%)/50*(1-10%)) + 5% = 14.80%