Question

The cost of external equity capital raised by issuing new common stock (r_e) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (r_s), divided by one minus the percentage flotation cost required to sell the new stock, (1 - F)."

Group of answer choices

True

False

Answer 1

Let D1 = Expected dividend per share next year , P0 = Current price of one share , g = Growth rate of dividends

F = Percentage flotation costs,

We know that

Then Cost of internal equity or retained earnings = (D1 / P0) + g................... (equation 1 )

Cost of External Equity = [D1 / P0(1-F)] + g ................................(equation 2)

Now dividing both the sides of equation 1 by (1-F) we get

Cost of internal equity / (1-F) = [D1/P0(1-F)] + g/(1-F)

Adding and subtracting g in RHS

Cost of internal equity / (1-F) = [D1/P0(1-F)] + g / (1-F) + g - g

Cost of internal equity / (1-F) = [D1/P0(1-F)] + g - g + g / (1-F)

Cost of internal equity / (1-F) = Cost of external equity - g + g / (1-F)

Cost of internal equity / (1-F) = Cost of external equity + g[{1/(1-F)} - 1]

Hence The cost of external equity is not equal to the cost of equity capital from retaining earnings , divided by one minus the percentage flotation cost required to sell the new stock, (1 - F).

Answer: False