Barton Industries expects next year's annual dividend, D1, to be $1.80 and it expects dividends...

Question:

Barton Industries expects next year's annual dividend, D1, to be $1.80 and it expects dividends to grow at a constant rate g = 4.5%. The firm's current common stock price, P0, is $22.90. If it needs to issue new common stock, the firm will encounter a 4.8% 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 answer to 2 decimal places. Do not round intermediate calculations.

Flotation Adjustment:

When firms issue new stocks, they must pay flotation costs that include underwriting fees and other transaction costs. Therefore, when estimating the cost of equity raised through new stock issuance, the flotation cost must be incorporated.

Answer and Explanation:

We can use the dividend growth model to answer the question. According to the model,

  • stock price = next dividend / (required return - dividend growth rate)

This pricing formula also implies the following:

  • required return = next dividend / stock price + dividend growth rate

First we can compute the cost of retained earnings using current stock price:

  • cost of retained earnings = 1.8/ 22.90 + 4.5%
  • cost of retained earnings = 12.36%

Next we can compute the cost of new equity. If the firm issues new stocks, the price per share it can receive is the current price net of flotation costs, i.e., 22.90*(1 - 4.8%) = 21.8008. Applying the dividend growth model again, the cost of new equity is:

  • cost of new equity = 1.8/ 21.8008 + 4.5%
  • cost of new equity = 12.76%

The flotation cost adjustment = 12.76% - 12.36% = 0.4%.


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Cost of Capital: Flotation Cost, NPV & Internal Equity

from Corporate Finance: Help & Review

Chapter 3 / Lesson 18
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