The common stock for the Bestsold Corporation sells for $64. If a new issue is s

Question

The common stock for the Bestsold Corporation sells for $64. If a new issue is sold, the flotation costs are estimated to be 11 percent. The company pays 80 percent of its earnings in dividends, and a $4.80 dividend was recently paid. Earnings per share 4 years ago were $4.00. Earnings are expected to continue to grow at the same annual rate in the future as during the past 4 years. The firm's marginal tax rate is 34 percent. Calculate the cost of (a) internal common equity and (b) external common equity.

Explanation / Answer

Growt Rate = g

So 5(1+g)4 =6

1+g = 1.21/4

g=1.0466-1 = 4.66%

Cost of New Equity / External Equity =(D1/Price × (1 F) )+ Growth Rate

Where,
D1 is dividend in next period
Price is the issue price of a share of stock
F is the ratio of flotation cost to the issue price
Growth Rate is the dividend growth rate

b. Cost of external common equity= (4.8*1.0466)/(64*(1-0.11)) + 0.0466 = 13.48%

a. Cost of  internal common equity = (D1/Price)+ Growth Rate =(4.8*1.0466)/64 + 0.0466 = 12.51%

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