Bay Beach Industries wants to maintain their capital structure of 40% debt and 6

Question

Bay Beach Industries wants to maintain their capital structure of 40% debt and 60% equity. The firm's tax rate is 34%. The firm can issue the following securities to finance the investments:

Bonds: Mortgage bonds can be issued at a pre-tax cost of 9 percent. Debentures can be issued at a pre-tax cost of 10.5 percent.

Common Equity: Some retained earnings will be available for investment. In addition, new common stock can be issued at the market price of $46. Flotation costs will be $3 per share. The recent common stock dividend was $3.60. Dividends are expected to grow at 6% in the future.

What is the cost of external equity?

Explanation / Answer

Cost of external equity = {D1/P0(1-f)} + g

D0 is the current dividend =$3.60

D1 is the Dividend for next year = D0 (1+g) =$3.60(1+0.06) = $3.816

P0 is the current price of the stock in the market. = $46

f = % of flotation cost

flotation cost =$3 per share

% of flotation cost = ($3/$46 ) * 100 = 6.5217391%

g is the growth rate of dividends = 6%

Substituting the values in the formula:

Cost of external equity= {$3.816 /$46(1-0.065217391)} + 0.06

= ($3.816/$43 )+ 0.06

= 0.148744 * 100 =14.87%

Therefore the cost of external equity = 14.87%.

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