Barton Industries expects next year's annual dividend, D1, to be $2.30 and it expects dividends to grow at a constant rate g = 4.6%. The firm's current common stock price, P0, is $20.50. If it needs to issue new common stock, the firm will encounter a 4.9% 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?
The flotation costs are expenses a firm must incur in order to issue new securities to the public. Examples of such costs include underwriting fees a firm must pay the investment bank, other legal and administrative expenses.
Answer and Explanation:
To find the flotation adjustment, we first compute the implied required return on the new stock, using the dividend growth model:
required return = next dividend / (price *(1 - flotation cost)) + dividend growth rate
required return = 2.3 / (20.5 *(1 - 4.9%)) + 4.6%
required return = 16.40%
The flotation cost adjustment = required return on new stocks - required return on equity without adjustment = 16.40% - 12% = 4.4%
The cost of new common equity = cost of old common equity + flotation cost adjustment = 11.5% + 4.4% = 15.9%.
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from Finance 101: Principles of FinanceChapter 14 / Lesson 3