Question

Premier Inc. has just determined its target capital structure: 40% debt, 10% preferred stock, and 50% common stock. Its 10% coupon, paid semiannually, 20-year bonds are currently yielding around 8% Premier is planning to issue new preferred stock at par, $100, paying 10% annual dividend. The flotation cost associated with the new issue is 5%. Premier just paid a dividend of $1, which has a constant growth rate of 5%. The firm's common stock is currently selling for $20, with a beta of 0.8. The risk-free rate of interest is 5% and the market's expected return is 10%. Premier's marginal tax rate is 35%.

If Premier has to issue new common stock with a 10% flotation cost, what is Premier's cost of new common equity?

Group of answer choices

12.33%

11.53%

10.83%

12.00%

Answer 1

Cost of new common equity (k_e):

ke D1 Po +9

Where
k_e = Cost of common equity
D₁ = Expected dividend next year
P₀ = Net proceeds from the sale of common stock
g = constant growth rate in decimal form

Now,

$=\$1 + (5\% \textup{ of } \$1)$

$1 + $0.05

= $1.05

and

$P_0 = \textup{Market price of stock - Flotation costs}$

$= \$20 - (10\%\textup{ of }\$20)$

Now substituting the values in the first formula, we get:

$k_e = \frac{\$1.05}{\$18} + 0.05$

$=0.10833$

OR

$=10.83\%$

Therefore, Premier's cost of new common equity is 10.83%