Question

If a firm plans to issue new stock, flotation costs (investment bankers' fees) should not be ignored. There are two approaches to use to account for flotation costs. The first approach is to add the sum of flotation costs for the debt, preferred, and common stock and add them to the initial investment cost. Because the investment cost is increased, the project's expected rate of return is reduced so it may not meet the firm's hurdle rate for acceptance of the project. The second approach involves adjusting the cost of common equity as follows:

The difference between the flotation-adjusted cost of equity and the cost of equity calculated without the flotation adjustment represents the flotation cost adjustment.

Quantitative Problem: Barton Industries expects next year's annual dividend, D₁, to be $1.90 and it expects dividends to grow at a constant rate g = 4.4%. The firm's current common stock price, P₀, is $20.00. If it needs to issue new common stock, the firm will encounter a 5.7% flotation cost, F. What is the flotation cost adjustment that must be added to its cost of retained earnings? Do not round intermediate calculations. Round your answer to two decimal places.

= %

What is the cost of new common equity considering the estimate made from the three estimation methodologies? Do not round intermediate calculations. Round your answer to two decimal places.

= %

Answer 1

a) What is the flotation cost adjustment that must be added to its cost of retained earnings?

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To find the flotation adjustment, we first compute the implied required return on the new stock,

using the dividend growth model:

Formula is:

Required return = D1 / ( P0 * (1 - F)) + g

Where,

D1 = next year's annual dividend = $1.90

P0 = current common stock price = $20

g = Growth rate = 4.4%

F = flotation cost = 5.7%

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required return new stock = $1.9 / ($20 * (1 - 5.7%)) + 4.4%

required return new stock = 1.9 / 18.86 + 5.7%

required return new stock = 0.1007 + 0.044

required return new stock = 0.1447 or 14.47%

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Now, cost of equity without flotation cost, which cost of retained earnings =

Cost of equity without flotation cost= ( $1.9 / $20 ) + 4.4%

Cost of retained earnings = 0.095 + 0.044

Cost of retained earnings = 0.139 or 13.90%

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The flotation adjustment cost = required return on new stocks - required return on equity without adjustment

required return on new stocks = 14.47%

required return on equity without adjustment = 13.90%

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The flotation adjustment cost = 14.47% - 13.90% = 0.57%

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b) What is the cost of new common equity

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cost of new common equity = cost of old common equity (cost of retained earnings ) + flotation adjustment

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cost of retained earnings = 13.90%

flotation adjustment = 0.57%

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cost of new common equity = 13.90% + 0.57% = 14.47%