Question

Determining the Cost of Capital: Cost of New Common Stock If a firm plans to issue new stock, flotation costs (investment bankers' fees) should not be ignored. There are two approaches to use to account for flotation costs. The first approach is to add the sum of flotation costs for the debt, preferred, and common stock and add them to the initial investment cost. Because the investment cost is increased, the project's expected return is reduced so it may not meet the firm's hurdle rate for acceptance of the project. The second approach involves adjusting the cost of common equity as follows: D Cost of equity from new stock =re = pi +gl The difference between the flotation-adjusted cost of equity and the cost of equity calculated without the flotation adjustment represents the flotation cost adjustment. Quantitative Problem: Barton Industries expects next year's annual dividend, D1, to be $2.50 and it expects dividends to grow at a constant rate gl = 4.6%. The firm's current common stock price, Po, is $24.90. If it needs to issue new common stock, the firm will encounter a 5.3% 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? Round your answer to 2 decimal places. Do not round intermediate calculations. % What is the cost of new common equity? Round your answer to 2 decimal places. Do not round intermediate calculations. %

Answer 1

Requirement (a) - Flotation cost adjustment that must be added to its cost of retained earnings

Step-1, Calculation of the cost of common stock

Dividend in year 1 (D1) = $2.50 per share

Current Share Price (P0) = $24.90 per share

Dividend Growth Rate (g) = 4.60% per year

Flotation Cost (FC) = 5.30%

Therefore, the cost of common stock (Ke) = D1/ [P0 (1 - FC)] + g

= [$2.50 / {$24.90(1 – 0.0530)}] + 0.0460

= [$2.50 / ($24.90 x 0.9430)] + 0.0460

= [$2.50 / $23.58] + 0.0460

= 0.1060 + 0.0460

= 0.1520 or

= 15.20%

Step – 2, flotation cost adjustment that must be added to its cost of retained earnings

Flotation Cost (FC) Adjustment = Cost of common stock - cost of equity calculated without the flotation adjustment

= 15.20% - 12.00%

= 3.20%

“Therefore, the Flotation cost adjustment to be added the cost of retained earnings will be 3.20%”

Requirement (b) - The cost of new common equity

Cost of new common equity (Ke) = Cost of old common equity + Floatation cost adjustment

= 11.50% + 3.20%

= 14.70%

“Hence, the cost of new common equity will be 14.70%”