Question

Quantitative Problem: Barton Industries expects next year's annual dividend, D1, to be $2.10 and it expects dividends to grow at a constant rate g = 4.1%. The firm's current common stock price, P0, is $24.40. If it needs to issue new common stock, the firm will encounter a 4.5% 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) = $2.10 per share

Current Share Price (P0) = $24.40 per share

Dividend Growth Rate (g) = 4.10% per year

Flotation Cost (FC) = 4.50%

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

= [$2.10 / {$24.40(1 – 0.0450)}] + 0.0410

= [$2.10 / ($24.40 x 0.9550)] + 0.0410

= [$2.10 / $23.30] + 0.0410

= 0.0901 + 0.0410

= 0.1311 or

= 13.11%

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

Flotation Cost (FC) Adjustment = 13.11% - 12.00%

= 1.11%

“Flotation cost adjustment to be added the cost of retained earnings would be 1.11%”

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% + 1.11%

= 12.61%

“The cost of new common equity = 12.61%”