The Cost of Capital: Cost of New Common Stock If a firm plans to issue new stock

Question

The Cost of Capital: Cost of New Common Stock If a firm plans to issue new stock, flotation costs (investment bankers' fees) should not be ignored. There are two approaches to use to account for flotation costs. The first approach is to add the sunm of flotation costs for the debt, preferred, and common stock and add them to the initial investment cost. Because the investment cost is increased, the project's expected return is reduced so it may not meet the firm's hurdle rate for acceptance of the project. The second approach involves adjusting the cost of common equity as follows Cost of equity from new stock - 1-F) The difference between the flotation-adjusted cost of equity and the cost of equity calculated without the flotation adjustment represents the flotation cost adjustment. uantitative Problem: Barton Industries expects next year's annual dividend, D, to be $1.80 and it expects dividends to grow at a constant rate g = 596. The firm's current common stock price, Po is $20.10 If it needs to issue new common stock the firm will encounter a 4.5% flotation cost F. Assume that the cost of equity calculated without the flotation adjustment is 12% and the cost of old common equity is 11.5% what is the flotation cost ad ustment that must be adde to its cost of retained earnings? Round your answer to 2 dea a paces. Do not round me mediate calculations. What is the cost of new common equity considering the estimate made from the three estimation methodologies? Round your answer to 2 decimal places. Do not round intermediate calculations.

Explanation / Answer

First, compute the cost of new equity with flotation adjustment using the formula given -

Cost of new equity = D0 / {P0 x (1 - F)} + g = $1.80 / {$20.10 x (1 - 0.045)} + 0.05 = 14.38%

Flotation cost adjstment is the difference between the above calculated cost of new equity with flotation adjustment and cost of equity without adjustment -

Flotation cost adjustment = 14.38% - 12% = 2.38%

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