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The common stock for the Bestsold Corporation sells for $58. If a new issue is sold, the...

Question:

The common stock for the Bestsold Corporation sells for $58. If a new issue is sold, the flotation costs are estimated to be 8 percent. The company pays 50% of its earnings in dividends, and a $4 dividend was recently paid. Earnings per share 5 years ago were $5. Earnings are expected to continue to grow at the same annual rate in the future as during the past 5 years. The firm's marginal tax rate is 34%.

Calculate the cost of (a) internal common equity and (b) external common equity.

Cost of equity:

Cost of equity is given as the cost of financing the projects or the operations of the company through the common stock or the retained earnings. It can be computed through several models of equity valuation and analysis.

Answer and Explanation:

Current earnings per share
= Current dividends / Payout ratio
= 4 / 0.50
= $8.00

Earnings per share 5 years ago = $5.00

For growth rate,

Current EPS = Past EPS x (1 + Growth rate)^Number of years

Here,

8 = 5 x (1 + Growth rate)^5

or,

Growth rate = 9.86%

Next year dividend
= Current dividend x (1 + Growth rate)
= 4 x 1.0986
= $4.3944

Current price = $58.00

Flotation cost = 8% = 0.08

Question a)

Cost of internal equity
= Next dividend / Price + Growth rate
= 4.3944 / 58 + 0.0986
= 17.44%

Question b)

Cost of external equity
= Next dividend / (Price net of flotation costs) + Growth rate
= 4.3944 / (58 x 92%) + 0.0986
= 18.10%


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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