Back to Assignment Attempts: Keep the Highest: 3 7. Problem 10.13 Problem 10-13

Question

Back to Assignment Attempts: Keep the Highest: 3 7. Problem 10.13 Problem 10-13 Cost of Common Equity with Flotation Ballack Co s common stock currently sells for $46.25 per share. The growth rate is a constant 14.4%, and the company has an expected dividend yield of 2%. The expected long-run dividend payout ratio is 20%, and the expected retum on equity (ROE) is 18%. New stock can be sold to the public at the current price, but a flotation cost of 10% would be incurred. What would be the cost of new equity? Round your answer to two decimal places. 9

Explanation / Answer

Cost of Equity using Floatation cots.

There are two schools of thoughts to using floatation costs.

1) The first states that it must be adjusted in the cost of equity model itself

Formulae: (Dividend next year/ Curent price (1-floatation costs(%)))+ Growth (%)

The drawback of this method is that it drastically channges the cost of equity permenantly while floatation cost is only a one time expenditure and not recurring but the effect of it is recurring due to usage of formulae.

Calculationin Approach 1:

Current Price: 46.25

Growth: 14.4%

Dividend Yield: 2%

Dividend per share: 0.925

Formulae:Cost of Equity= (Dividend next year/ Curent price (1-floatation costs))+ Growth (%)

Cost of Equity= [{0.925*(1+14.4%)}/{46.25*(1-10%)}]+14.4%

                         =16.94%

2) In the second method the floation costs are consierred as a one time expenditure and hence adjusted and subtracted in the NPV calculation like initial cash outflow. This methd is preferred by many as being a one time expense it should not permenantly impact the cost of equity. Therefore it is subtracted as if it were initial cash outflow while calculating NPV. In this case it has no effect on cost of equity

Approach 2:

Formulae: (Dividend next year/ Curent price)+ Growth (%)

Cost of Equity: [{0.925*(1+14.4%)}/46.25]+14.4%

                           =16.69%

It is upto you to chose the method although suggestion would be to use Approach 2 and incorporate floatation costs in NPV calculation thus having no effect on Cost of Equity

Assumption: The dividend yield is for current year and hence growth has been added for next year dividend.

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