Myers Corporation's stock currently trades at $40 a share. Investors estimate that the year-end...

Question:

Myers Corporation's stock currently trades at $40 a share. Investors estimate that the year-end dividend will be $2.00 a share and that its dividend will grow at 5% a year. The company needs to issue new stock in order to fund its upcoming projects, and investment bankers estimate that the flotation cost will be 4%.

What is Myers' cost of new external equity?

Flotation Costs:

In order to issue a security, the firms have to pay some external costs such as advertisement, underwriting, legal fees, etc. These costs add up to the cost of the debt or equity and are known as Flotation costs.

Answer and Explanation:


Myers' cost of new equity is 10.21%


We need to adjust the price for the flotation costs:$40* ( 1 - 4%)
=$38.40

We now apply the dividend growth model:

{eq}Price = \dfrac{D_{1}}{r-g} {/eq}

Here:

  • D1 is the year end dividend = $2.00
  • r is the cost of equity
  • g is the dividend growth rate = 5.00% or 0.05
  • Price = $38.40

Plugging in the values we have:

{eq}$38.40 = \dfrac{ $ 2.00 }{ r -0.05} {/eq}

{eq}r - 0.05 = \dfrac{ $ 2.00 }{ $ 38.40 } {/eq}

{eq}r = 0.1021 {/eq}


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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