Question

Quantitative Problem: Barton Industries expects next year's annual dividend, D₁, to be $2.00 and it expects dividends to grow at a constant rate g = 4%. The firm's current common stock price, P₀, is $20.60. If it needs to issue new common stock, the firm will encounter a 5.4% 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.
%

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

(a)- The flotation cost adjustment that must be added to its cost of retained earning

The flotation-adjusted cost of equity is calculated using the following formula

Flotation-adjusted cost of common stock = [D1 / {P0 (1 – FC)}] + g

Where, D1 = Dividend in next year

P0 = Current Shares Price

FC = Flotation Cost

g = Growth Rate

Flotation-adjusted cost of equity = [D1 / {P0 x (1 – FC)}] + g

= [$2.00 / {$20.60 x (1 – 0.054)] + 0.04

= [$2.00 / $19.49] + 0.04

= 0.1026 + 0.04

= 0.1426

= 14.26%

The flotation cost adjustment that must be added to its cost of retained earning

= Flotation-adjusted cost of equity - cost of equity calculated without the flotation adjustment

= 14.26% - 12%

= 2.26%

“Therefore, the flotation cost adjustment that must be added to its cost of retained earning = 2.26%”

(b)- The cost of new common equity

The cost of new common equity = Cost of old common equity + Flotation cost adjustment

= 11.50% + 2.26%

= 13.76%

“The cost of new common equity = 13.76%”