Question

A company is planning to issue new common stock. The expected dividend next year is $2.50, and the expected sales price is $35.00. The company's earnings are expected to grow at a constant rate for the foreseeable future. The return on S&P 500 is 8%, and the U.S. Treasury is traded at 3%. The flotation cost of issuing new common stock is 7%. If the company's stock has a beta of 1.55, what is the cost of common equity? 10.00% 16.48% 6.68% 7.68% 11.50%

Answer 1

The option is E) 11.5%

You need to have 2 knowledge to solve this question.

1. CAPM Model.

2. Cost of Equity is greater than Required rate of return by Equity share holders whenever flotation cost is involved.

Cost of Equity = Required rate of return(Re) + flotation cost.

As per CAPM Model:

Re= Rf + (Rm-Rf)B

= 3+(8-3)*1.55

= 10.75%

Flotation cost is 7%

So cost of Equity = 10.75 + 10.75(7%) or 10.75(1.07)

= 11.5025%

Hence the answer is E) 11.50%

Thank you. Hope you find the solution helpful.