Question

True or False: The following statement accurately describes how firms make decisions related to issuing new common stock. The cost of issuing new common stock is calculated the same way as the cost of raising equity capital from retained earnings. O True: The cost of retained earnings and the cost of new common stock are calculated in the same manner, except that the cost of retained earnings is based on the firm's existing common equity, while the cost of new common stock is based on the value of the firm's share price net of its flotation cost. False: Flotation costs need to be taken into account when calculating the cost of issuing new common stock, but they do not need to be taken into account when raising capital from retained earnings. White Lion Homebuilders is considering investing in a one-year project that requires an initial investment of $500,000. To do so, it will have to 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 White Lion expects to earn on its project (net of its flotation costs) is (rounded to two decimal places). Alpha Moose Transporters has a current stock price of $22.35 per share, and is expected to pay a per-share dividend of $2.45 at the end of the year. The company's earnings' and dividends' growth rate are expected to grow at the constant rate of 5.20% into the foreseeable future. If Alpha Moose expects to incur flotation costs of 3.750% of the value of its newly-raised equity funds, then the flotation-adjusted (net) cost of its new common stock (rounded to two decimal places) should be White Lion Homebuilders Co.'s addition to earnings for this year is expected to be $857,000. Its target capital structure consists of 50% debt, 5% preferred, and 45% equity. Determine White Lion Homebuilders's retained earnings breakpoint: $1,904,444 $1,999,666 $1,809,222 $2,190,111

Answer 1

False - When calculating cost of issuing new stock, flotation costs have to be taken into account while for cost of retained earnings, there are no flotation costs.

Fill in the blanks:

1). Return earned on the project = (cash inflow/investment*(1+flotation cost)) -1

= (595,000/(500,000*(1+2%)) -1 = 16.67%

2). Cost of new common stock (k) = g + (D1/P0*(1-f)) = 5.2% + (2.45/(22.35*(1-3.75%)) = 16.59%

3). Retained earnings breakpoint will be the point at which new stock will have to be issued. This will happen after the entire retained earnings has been used up. So, the breakpoint will be addition to earnings/%age of equity in the capital structure

= 857,000/45% = 1,904,444 (option a)

4). WACC = sum of weighted costs of capital = (weight of debt*cost of debt*(1-tax rate)) + (weight of preferred stock*cost of preferred stock) + (weight of equity*cost of equity)

WACC with retained earnings = (45%*11.1%*(1-25%)) + (4%*12.2%) + (51%*14.7%) = 11.73%

WACC with new common stock = (45%*11.1%*(1-25%)) + (4%*12.2%) + (51%*16.8%) = 12.80%

WACC will be higher by 12.80% - 11.73% = 1.07% (option b)

5). WACC = 10.12%

	Amount (A)	Weight (W = A/T)	Cost (C)
Debt	750000	43.91%	6.53%
Preferred stock	78000	4.57%	9.90%
Equity	880000	51.52%	13.20%
Total (T)	1708000	100.00%
WACC			10.12%

6). Cost of debt: PV = -1,050.76; PMT (annual coupon payment) = 10%*1,000 = 100; FV = 1,000; N = 5, solve for rate.

YTM (or pre-tax cost of debt) = 8.70%

After-tax cost of debt = 8.70%*(1-25%) = 6.53%

Cost of preferred shares = annual dividend/current price = 8/95.7 = 8.36%

Cost of common equity = g + (D1/P0*(1-f)) = 9.2% + (1.36/(33.35*(1-3%))) = 13.40%

Using the given weights, WACC is

(45%*6.53%) + (4%*8.36%) + (51%*13.40%) = 10.11%