Bouchard Company's stock sells for $20 per share, its last dividend was $1.00, its growth rate is...

Question:

Bouchard Company's stock sells for $20 per share, its last dividend was $1.00, its growth rate is a constant 5%, and the company would incur a flotation cost of 7% if it sold new common stock. Retained earnings for the coming year are expected to be $1,000,000, and the common equity ratio is 55%.

If Bouchard has a capital budget of $2,000,000, what component cost of common equity will be built into the WACC for the last dollar of capital the company raises?

A) 11.29%

B) 11.61%

C) 11.40%

D) 10.22%

E) 10.65%

Cost of equity:

Cost of equity refers to the cost of financing the project from equity financing. Equity financing can be internal, which is from retained earnings, or it can be external, which is from a fresh issue of common stock.

Answer and Explanation:

The correct choice is Option E.

Required equity budget
= Capital budget x Equity weight
= $2,000,000 x 55%
= $1,100,000.00

Retained earnings = $1,000,000.00

So, External equity needs to be raised for = $1,100,000 - $1,000,000 = $100,000.00

Now,

Cost of external equity
= Expected dividend / Net Price + Growth rate

So,

Expected dividend
= Current dividend x (1 + Growth rate)
= 1.00 x 1.05
= $1.05

Growth rate = 5% = 0.05

Net Price
= Price x (100 - Flotation cost rate)
= 20 x 93%
= $18.60

Cost of external equity
= 1.05 / 18.60 + 0.05
= 10.65%

Now,

Since the last dollar will be raised by raising common equity, required cost of capital = 10.65%


Learn more about this topic:

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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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