Quantitative Problem: Barton Industries expects next year\'s annual dividend, D1
ID: 2566300 • Letter: Q
Question
Quantitative Problem: Barton Industries expects next year's annual dividend, D1, to be $2.10 and it expects dividends to grow at a constant rate g = 5%. The firm's current common stock price, P0, is $20.80. If it needs to issue new common stock, the firm will encounter a 5.1% 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 adjustment that must be added to its cost of retained earnings? Round your answer to 2 decimal places. Do not round intermediate 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
Floatation Costs in relation with corporate finance, refer to the costs associated with issue of securities by a corporation. These include a variety of expenses like legal fees, underwriting fees, brokerage expenses etc. In all, they are incurred in relation with sale of securities.
Difference between Cost of New Equity and Cost of Old Equity is termed as Floatation Cost Adjustment, since incorporation of floatation cost makes the Cost of New Equity higher than Cost of Existing Equity. Floatation Costs hence, necessitate a higher return to be earned on newly issued stock.
Hence to calculate the Floatation Cost Adjustment, both Cost of Old as well as New Equity are required.
Cost of Old Equity has been provided in the question.
Cost of New Equity can be calculated as below:
Ke = D1/[P0-(1-f)] + g, where
Ke = Cost of Equity
D1 = Dividend Expected Next Year
P0 = Prevailing Price of Equity
f = Floatation Cost
g = Expected Growth Rate
So, Cost of New Equity = Ke = D1/[P0*(1-f)] + g
or Ke = 2.10/ [20.80 * (1-0.051)] + 0.05
= 2.10/ [20.80 * 0.949] + 0.05
= 2.10/ 19.7392 + 0.05
= 0.10638 + 0.05 = 0.15638 or 15.64%
Floatation Cost Adjustment = Cost of New Equity – Cost of Existing Equity
= 15.64 – 11.50 = 4.14%
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