Question

Read each of the following statements, and indicate whether each statement is true or false.

A: Firms will raise all the common equity they can from retained earnings before issuing new common stock, because capital from retained earnings is less expensive than capital raised from issuing new common stock.

B: The flotation costs associated with the sale of debt securities are greater than those associated with new common stock issues

C: Firms raise capital from retained earnings only when they cannot issue new common stock due to market conditions outside of their control.

Consider the case of White Lion Homebuilders:

White Lion Homebuilders has a current stock price of $41 per share, and is expected to pay a per-share dividend of $3.30 at the end of next year. The company’s earnings and dividends growth rate are expected to grow at a constant rate of 5.50% into the foreseeable future. If Alpha Moose expects to incur flotation costs of 3.95% of the value of its newly-raised equity funds, then the flotation-adjusted (net) cost of its new common stock (rounded to two decimal places) should be D: 12.49% OR 13.88% OR 15.27% OR 13.5488%

Answer 1

(A)-Firms will raise all the common equity they can from retained earnings before issuing new common stock, because capital from retained earnings is less expensive than capital raised from issuing new common stock – TRUE

(B)-The flotation costs associated with the sale of debt securities are greater than those associated with new common stock issues - FALSE

(C)-Firms raise capital from retained earnings only when they cannot issue new common stock due to market conditions outside of their control – TRUE

The flotation-adjusted (net) cost of its new common stock

Here, we’ve Dividend in year 1 (D1) = $3.30 per share

Current Share Price (P0) = $41.00 per share

Dividend Growth Rate (g) = 5.50% per year

Flotation Cost (FC) = 3.95%

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

= [$3.30 / {$41.00(1 – 0.0395)}] + 0.0550

= [$3.30 / ($41.00 x 0.9605)] + 0.0550

= [$3.30 / $39.3805] + 0.0550

= 0.0838 + 0.0550

= 0.1388 or

= 13.88%

“Hence, the flotation-adjusted (net) cost of its new common stock will be 13.88%”