Barton Industries expects next year's annual dividend to be $2.10 and it expects dividends to grow at a constant rate g = 4.6%. The firm's current common stock price is $23.40. If it needs to issue new common stock, the firm will encounter a 4.4% flotation cost. 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.
It is the cost incurred to bring new equity in the market. Every time, new equity is issued, the company has to incur some cost to float the equity in the stock market. This is why it is not considered prudent to finance new ventures repetitively with equity finance.
Answer and Explanation:
Next year's annual dividend, D1 = $2.10
Dividend growth rate, g = 4.6%
Current common stock price, P0 = $23.40
Flotation Cost, F = 4.4%
We know that Cost of new common equity, Ke = D1 / (P0 x (1 - F) + g)
Ke = 2.10 / (23.4 x (1 -.044)) + 0.046
= 2.10 / 22.3704 + 0.046 = 0.13987 or 13.99%
So, flotation adjustment = 13.99% - cost of equity calculated without the flotation adjustment, 12% = 0.0199 or 1.99%
So, cost of new common equity = Old common equity cost + floatation adjustment = 11.5% + 1.99% = 0.1348 or 13.49%
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from Corporate Finance: Help & ReviewChapter 3 / Lesson 18