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 = 4.9%. The firm's current common stock price, P0, is $22.30. If it needs to issue new common stock, the firm will encounter a 4.3% 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?

What is the cost of new common equity considering the estimate made from the three estimation methodologies?

Flotation Cost:

There are two ways to account for flotation cost in capital budgeting. One is to add the dollar flotation cost to the project cash flows. The other is to add a flotation cost adjustment to the cost of capital.

Answer and Explanation: 1

Let

  • D1 = dividend next year
  • P0 = stock price
  • F = flotation cost
  • re = cost of equity
  • g = growth rate

The cost of new equity, re, including the flotation cost, can be found using the formula

{eq}r_{e}=\frac{D_{1}}{P_{0}*(1-F)}+g=\frac{1.8}{22.3*(1-0.043)}+0.049\\ r_{e}=0.133 {/eq}

Flotation cost adjustment = 13.3% - 12% = 1.3%.

Therefore, the cost of retained earnings, including the adjustment is:

Retained earnings cost = 11.5% + 1.3% = 12.8%

The three estimation methodologies give 3 different estimates for the cost of equity. These are 12% (the cost without adjustment), 12.8% (The cost of retained earnings with adjustment), and 13.3% (the cost of new equity with adjustment). The appropriate cost of equity would be 12% if the company does not issue new equity and 13.3% if the company issues new equity.


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Cost of Capital: Flotation Cost, NPV & Internal Equity

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Chapter 3 / Lesson 18
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How does a business figure out the true cost and best means of obtaining capital? In this lesson, we will explore the cost of capital, flotation cost, net present value, and internal equity to help answer that question.


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