Question

Barton Industries expects next year's annual dividend, D1, to be $2.10 and it expects dividends to grow at a constant rate gL = 4.9%. The firm's current common stock price, P0, is $24.20. If it needs to issue new common stock, the firm will encounter a 5.7% 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? 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

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) = $2.10 per share

Current Share Price (P0) = $24.20 per share

Dividend Growth Rate (g) = 4.90 per year

Flotation Cost (FC) = 5.70%

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

= [$2.10 / {$24.20(1 – 0.0570)}] + 0.0490

= [$2.10 / ($24.20 x 0.9430)] + 0.0490

= [$2.10 / $22.8206] + 0.0490

= 0.0920 + 0.0490

= 0.1410 or

= 14.10%

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

Flotation Cost (FC) Adjustment = Cost of common stock - cost of equity calculated without the flotation adjustment

= 14.10% - 12.00%

= 2.10%

“Therefore, the Flotation cost adjustment to be added the cost of retained earnings would be 2.10%”

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% + 2.10%

= 13.60%

“The cost of new common equity = 13.60%”