Question

Quantitative Problem: Barton Industries expects next year's annual dividend, D₁, to be $1.70 and it expects dividends to grow at a constant rate g = 4.6%. The firm's current common stock price, P₀, is $20.50. If it needs to issue new common stock, the firm will encounter a 5.6% flotation cost, F. Assume that the cost of equity calculated without the flotation adjustment is 12% and the cost of old common equity is 11.5%. What is the flotation cost adjustment that must be added to its cost of retained earnings? Round your answer to 2 decimal places. Do not round intermediate calculations.
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What is the cost of new common equity considering the estimate made from the three estimation methodologies? Round your answer to 2 decimal places. Do not round intermediate calculations.

Answer 1

Requirement (a) - Flotation cost adjustment that must be added to its cost of retained earnings

Step-1, Calculation of the cost of common stock

Dividend in year 1 (D1) = $1.70 per share

Current Share Price (P0) = $20.50 per share

Dividend Growth Rate (g) = 4.60% per year

Flotation Cost (FC) = 5.60%

Therefore, the cost of common stock (Ke) = D1/ [P0 (1 - FC)] + g

= [$1.70 / {$20.50(1 – 0.0560)}] + 0.0460

= [$1.70 / ($20.50 x 0.9440)] + 0.0460

= [$1.70 / $19.3520] + 0.0460

= 0.0878 + 0.0460

= 0.1338 or

= 13.38%

Step – 2, flotation cost adjustment that must be added to its cost of retained earnings

Flotation Cost (FC) Adjustment = Cost of common stock - cost of equity calculated without the flotation adjustment

= 13.38% - 12.00%

= 1.38%

“Therefore, the Flotation cost adjustment to be added the cost of retained earnings will be 1.38%”

Requirement (b) - The cost of new common equity considering the estimate made from the three estimation methodologies

Cost of new common equity (Ke) = Cost of old common equity + Floatation cost adjustment

= 11.50% + 1.38%

= 12.88%

“Hence, the cost of new common equity will be 12.88%”