Question

COST OF EQUITY WITH AND WITHOUT FLOTATION

Jarett & Sons's common stock currently trades at $28.00 a share. It is expected to pay an annual dividend of $2.00 a share at the end of the year (D₁ = $2.00), and the constant growth rate is 3% a year.

1. What is the company's cost of common equity if all of its equity comes from retained earnings? Round your answer to two decimal places. Do not round your intermediate calculations.
   %
2. 
   
3. If the company issued new stock, it would incur a 16% flotation cost. What would be the cost of equity from new stock? Round your answer to two decimal places. Do not round your intermediate calculations.
   %

Answer 1

Answer to a :- What is the company's cost of common equity if all of its equity comes from retained earnings?

Now, Given the price of Security(P) = $ 28

Also D1 = Epected Dividend = $ 2

and Constant growth rate (g) = 3%

According Dividend Discount Model we have the formula for calculating price of the security

P=D1(Re-G)

Where Re is the Cost of equity or the required rate of return

Now, we have

28 = 2/(Re-.03)

Solving for Re = (2/28)+0.03

Re= 10.14%

Answer to b :- If the company issued new stock, it would incur a 16% flotation cost. What would be the cost of equity from new stock?

Now, we have the floatation cost of 16%. Therefore Cost of Equity (Re) can be computed using the following formula

Re = [D1/P(1-f)]+g

where D1 = Expetced Dividend - $2

P = Price of The security = $28

F = Floatation Cost = 16%

g= Growth Rate = 3%

Therefore we have Re = [2/28(1-0.16)]+0.03

Re= 11.50%

If the floatation cost is 16%, the cost of Equity will be 11.50%