The common stock for Grapevine Plumbing Company currently sells for $40 per share. If a new issue is sold the flotation cost is estimated to be $7 per share. The company had earnings of $2.00 per share four years ago. Next year the company expects to have earnings of $3.22 per share. The company maintains a constant dividend payout ratio of 40 percent. Earnings per share are anticipated to grow at the same rate in the future. The firm's marginal tax rate is 30 percent. Calculate the cost of internal equity capital and external equity capital.
Explanation / Answer
Growth rate has to be find out first: From the availble information eaarning per share at present =$ 3.22 where 4 years back = $2.00 growth rate : 2*(1+g)^4 = 3.22 (1+g)^4= 3.22 / 2 (1+g)^4 = 1.61 1+g = 1.61^(1/4) 1+g= 1.1264 growth rate = 1.1264-1 12.64% Interenal cost of equity rE = (D1 / P0) + g D1 = 3.22* 40% = $1.288 = (1.288/ 40 ) +12.64% = 3.22% + 12.64% = 15.86% External cost of capital : = [D1 / P0*(1-f)]+ g =[1.288 / 40*(1-[7/40]]+ 12.64% =[1.288 / 40*0.825] +12.64% =[1.288 / 33] + 12.64% = 3.9% + 12.64% = 16.54% Note: Please observe that cost of internal equity means the flatation cost has to be excluded, and for external cost of equity , the flotation cost has to be include.