The management of the Company needs to estimate the cost of its equity financing
ID: 2769999 • Letter: T
Question
The management of the Company needs to estimate the cost of its equity financing. The latest financial data is as follows: stock price of $25.00; next expected dividend is $1.25 per share; constant expected growth rate in dividends and earnings of 5%; beta of the stock is 1.2; current market rate is 9%; risk-free rate of return is 3%. a) (6 pts) all the above information, what is a good estimate of the cost of equity? SHOW ALL WORK for full credit. b) (2 pts) If flotation costs of issuing new common stock is 15% of the stock price, what is the cost of new common stock? SHOW ALL WORK for full credit.
Explanation / Answer
Required return (CAPM) = Rf+×Rp
Rf is risk free return
Rp is risk premium
= 3%+1.2×(9%-3%)
= 10.2%
Stock price, P0 = D1÷(r-g)
D1 is next expected dividend
r is required return
g is growth rate
$25 = $1.25÷(10.2%-g)
Growth rate, g = 5.2%
Cost of equity, re = D1÷[Price×(1-F)]+Growth rate
D1 is expected dividend
F is flotation cost
= $1.25÷[$25×(1-15%)]+5.2%
Cost of new common stock = 11.08%
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