True or False: The following statement accurately describes how firms make decis

Question

True or False: The following statement accurately describes how firms make decisions related to issuing new common stock. The cost of issuing new common stock is calculated the same way as the cost of raising equity capital from retained earnings. True: The cost of retained earnings and the cost of new common stock are calculated in the same manner, except that the cost of retained earnings is based on the firm's existing common equity, while the cost of new common stock is based on the value of the firm's share price net of its flotation cost. False: Flotation costs need to be taken into account when calculating the cost of issuing new common stock, but they do not need to be taken into account when raising capital from retained earnings. White Lion Homebuilders is considering investing in a one-year project that requires an initial investment of $450,000. To do so, it will have issue new common stock and will incur a flotation cost of 2.00%. At the end of the year, the project is expected to produce a cash inflow of $550,000. The rate of return that White Lion expects to earn on its project (net of its flotation costs) is (rounded to two decimal places). Alpha Moose Transporters has a current stock price of $22.35 per share, and is expected to pay a per-share dividend of $1.36 at the end of next year. The company's earnings' and dividends' growth rate are expected to grow at the constant rate of 9.40% into the foreseeable future. If Alpha Moose expects to incur flotation costs of 6.50% of the value of its newly-raised equity funds, then the flotation-adjusted (net) cost of its new common stock (rounded to two decimal places) should be

Explanation / Answer

A - False. Flotation cost needs to be taken into account while calculating cost of new equity

B - With flotation cost of 2%, amount that needs to be raised = 450,000 / (1 - 2%) = 459,184

Rate of return = CF1 / CF0 - 1 = 550,000 / 459,184 - 1 = 19.78%

C - Cost of new equity = D1 / (P x (1 - f)) + g = 1.36 / (22.35 x (1 - 6.5%)) + 9.4% = 15.91%

D - Break-even point for equity = Retained Earnings / Weight of equity = 857,000 / 55% = 1,558,182

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