Quantitative Problem: Barton Industries expects next year\'s annual dividend, D1
ID: 2732229 • Letter: Q
Question
Quantitative Problem: Barton Industries expects next year's annual dividend, D1, to be $2.40 and it expects dividends to grow at a constant rate g = 4.8%. The firm's current common stock price, P0, is $24.80. If it needs to issue new common stock, the firm will encounter a 4.8% 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.
Explanation / Answer
If the firm has a flotation cost of 4.8%, its cost of new outside equity is calculated as follows :
2.40 / 24.80*(1-0.048) + 0.048 = 14.97%
If the firm can earn 14.97% on investments financed by new common stock, then earnings, dividends, and the growth rate will be maintained, and the price per share will not fall. If it earns more than 14.97%, the price will rise; while if it earns less, the price will fall.
The flotation cost adjustment is the amount that must be added to rs to account for flotation costs to find re. Flotation adjustment = Adjusted DCF cost – Pure DCF cost
= 14.97% – 12% = 2.97%.