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 = 4.8%. The firm's current common stock price, P₀, is $21.90. 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

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) = $2.00 per share

Current Share Price (P0) = $21.90 per share

Dividend Growth Rate (g) = 4.80% per year

Flotation Cost (FC) = 5.40%

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

= [$2.00 / {$21.90(1 – 0.0540)}] + 0.0480

= [$2.00 / ($21.90 x 0.9460)] + 0.0480

= [$2.00 / $20.7174] + 0.0480

= 0.0965 + 0.0480

= 0.1445 or

= 14.45%

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

Flotation Cost (FC) Adjustment = 14.45% - 12.00%

= 2.45%

“Flotation cost adjustment to be added the cost of retained earnings would be 2.45%”

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% + 2.45%

= 13.95%

“The cost of new common equity = 13.95%”