Question

Banyan Co.’s common stock currently sells for $30.25 per share. The growth rate is a constant 5%, and the company has an expected dividend yield of 4%. The expected long-run dividend payout ratio is 50%, and the expected return on equity (ROE) is 10.0%. New stock can be sold to the public at the current price, but a flotation cost of 10% would be incurred. What would be the cost of new equity? Do not round intermediate calculations.

Round your answer to two decimal places.

Answer 1

Solution:
	Cost of new equity Ke             9.44%
Working Notes:
	Using Gordon growth model : P0 x (1 - F) = D1 / (Ke - g)
	ke = New cost of Equity
	Po=current share price = $30.25 per share
	g= growth rate= 5%
	D1 = Expected dividend in a year= ??
	Flotation cost F = 10%
	Additional details given
	Dividend yield = 4%
	D/P = dividend payout ratio = 50%
	return on equity (ROE) = 10.0%
Now	Dividend yield = D1/P0
	D1= Dividend yield x P0
	D1= 4% x $30.25
	D1= $1.21
	Growth rate g can be computed using ROE & D/P ratio
	g = ROE x ( 1- D/P)
	g = 10% x ( 1- 50%)
	g = 10% x 50%
	g = 5%
	which is already given
hence	Cost of new equity we calculate
	P0 x (1 - F) = D1 / (Ke - g)
	30.25 x (1 - 10%) = 1.21 / (Ke - 5%)
	1.21/(30.25 x (1 - 10%)) + 5% = Ke
	Ke = 1.21/(27.225) + 5%
	Ke = 0.04444444+ 5%
	Ke = 4.44444% + 5%
	Ke = 9.444444%
	Ke = 9.44%
Please feel free to ask if anything about above solution in comment section of the question.