Question

JKL Company has a 40% tax rate. JKL's bonds presently carry a yield to maturity of 9.23%. The common stock just paid a dividend of $2.20, is expected to grow at 4% per year forever and costs $18.33 per share. Flotation costs for new common stock are 8%. The capital structure consists of 40% debt and 60% common equity.

a) What is the cost of equity if no new common or preferred stock is issued?

   b) What is the new cost of equity if new common must be issued?

           

Answer 1

Expected Dividend = Current Dividend * (1 + Growth Rate)
Expected Dividend = $2.20 * 1.04
Expected Dividend = $2.288

Answer a.

Cost of Equity = Expected Dividend / Current Price + Growth Rate
Cost of Equity = $2.288 / $18.33 + 0.04
Cost of Equity = 0.1248 + 0.04
Cost of Equity = 0.1648 or 16.48%

Answer b.

Cost of Equity = Expected Dividend / [Current Price * (1 - Flotation Cost)] + Growth Rate
Cost of Equity = $2.288 / [$18.33 * (1 - 0.08)] + 0.04
Cost of Equity = $2.288 / $16.8636 + 0.04
Cost of Equity = 0.1357 + 0.04
Cost of Equity = 0.1757 or 17.57%