Pharmaceuticals is a new company that will manufacture and deliver generic drugs

Question

Pharmaceuticals is a new company that will manufacture and deliver generic drugs to the residents of Hoboken at a subsidized price. They need to raise $10,000,000 in order to build their new manufacturing plant and distribution center. The Pharmacy Depot’s target capital structure calls for a debt ratio of 50%. Therefore, $5 million needs to be financed from equity from the following sources:

Using the following 4 steps, calculate the cost of equity required to finance this new venture:

1. Cost of retained earnings
2. Flotation costs for common stock

3. Flotation costs for preferred stock

4. Cost of Equity

Explanation / Answer

1. Cost of retained earnings-

Using the dividend-growth model :

Kre = D1/P0 + G

where:
D1 = next year's dividend = $15
g = firm's constant growth rate = 10.5%
P0 = price = $100

therefore Kre = 15/100 + 10.5%

   Kre = 25.5%

2. Flotation costs for common stock = $90 x 18%

= $16.20

3. Flotation costs for preferred stock = $160 x 10%

   = $16

4. Cost of Equity -

Ke = D1 / Price x (1-F) + g

Where,
D1 is dividend in next period = $15
Price is the issue price of a share of stock = $90
F is the ratio of flotation cost to the issue price = 18%
g is the dividend growth rate = 10.5%

Ke = 15 / 90 x (1-18%) + 10.5%

   = 20.33 + 10.5

Ke = 30.83%

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