Question

Barton Industries expects next year's annual dividend, D1, to be $1.60 and it expects dividends to grow at a constant rate g = 4.8%. The firm's current common stock price, P0, is $20.90. If it needs to issue new common stock, the firm will encounter a 5.3% 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

Requirement (a) - Flotation cost adjustment that must be added to its cost of retained earnings

Step-1, Calculation of the cost of common stock

Dividend in year 1 (D1) = $1.60 per share

Current Share Price (P0) = $20.90 per share

Dividend Growth Rate (g) = 4.80 per year

Flotation Cost (FC) = 5.30%

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

= [$1.60 / {$20.90(1 – 0.0530)}] + 0.0480

= [$1.60 / ($20.90 x .9470)] + 0.0480

= [$1.60 / $19.79] + 0.0480

= 0.0808 + 0.0480

= 0.1288 or

= 12.88%

Step – 2, flotation cost adjustment that must be added to its cost of retained earnings

Flotation Cost (FC) Adjustment = 12.88% - 12.00%

= 0.88%

“Flotation cost adjustment to be added the cost of retained earnings would be 0.88%”

Requirement (b) - The cost of new common equity considering the estimate made from the three estimation methodologies

Cost of new common equity (Ke) = Cost of old common equity + Floatation cost adjustment

= 11.50% + 0.88%

= 12.38%

“The cost of new common equity = 12.38%”