Question

6. Cost of new common stock

6. Cost of new common stock Aa Aa E True or False: The following statement accurately describes how firms make decisions related to issuing new common stock. If a firm needs additional capital from equity sources once its retained earnings breakpoint is reached, it will have to raise the capital by issuing new common stock. True: Firms will raise all the equity they can from retained earnings before issuing new common stock because capital from retained earnings is cheaper than capital raised from issuing new common stock. False: Firms raise capital from retained earnings only when they cannot issue new common stock due to market conditions outside of their control. Sunny Day Manufacturing Company is considering investing in a one-year project that requires an initial investment of $450,000. To do so, it will have issue new common stock and will incur a flotation cost of 2.00%. At the end of the year, the project is expected to produce a cash inflow of $595,000. The rate of return that Sunny Day expects to earn on its project (net of its flotation costs) is (rounded to two decimal places).

Answer 1

rate positively ..

Answer a)	statement is TRUE : Firm will raise all equity they can from retained earning before issuing new common stock, because capital from retained earning is cheaper than capital from issuing new common stock
Answer b)
	intial investment			450000
	Flotation cost			2%
	Therefore firm must need to raise 450000/(1-2%) to get net of 475000 as investable amount
i	Total cost of investment =		=450000/98%	459183.7
ii	expected cash inflow =				595000
iii=ii-i	return					135816.33
iv=iii/i	rate of return					29.58%
Answer c)	Current share price =			33.35
	Expected dividend =				2.03
	growth rate =				8.70%
	flotation cost =				6.50%
	We can use DDM model to find the cost of common equity
	Formula used =
	cost of equity =		Expected dividend/ (Price *(1-flotation cost)) + growth rate
			=(2.03/(33.35*(1-6.5%))+8.7%)
			15.21%
Answer d)
	retained earning breakpoint is the point where firm need not to go with issuing if new stock .
	Given that current equity ratio = 60%
	Additional earning =			745000
	At current capital structure firm need not to go for issue of new stock upto the investment of = 745000/60%
	earning breakpoint			1241667
	hence, correct answer is option :	1241667