Question

In order to meet their capital needs for next year a firm will need to sell some additional shares of their Class A Common Stock. Flotation costs are estimated to be $2.75 per share. Class A shares currently trade at $70.00 and most recently paid a dividend of $7.00 per share. The firm expects to grow at a constant 5.00% for the foreseeable future. Calculate the firm’s cost of common equity from new shares.

Answer 1

The firm's cost of common equity from issuing new shares, after accounting for flotation costs, is calculated using the Dividend Discount Model (DDM) and is determined to be 15.92%.

Step-by-step explanation:

The firm’s cost of common equity from new shares can be calculated using the Dividend Discount Model (DDM) for a perpetuity, which states that the price of a stock with constant growth can be found using the formula P = D / (k - g), where P is the price of the stock, D is the dividend per share, k is the cost of equity, and g is the growth rate. However, we must adjust for flotation costs to find the cost of issuing new shares.

To find the cost of equity using DDM: k = (D1 / P0) + g, where D1 is the expected future dividend, which would be $7.00 multiplied by the growth rate of 5% for this firm. Calculating D1: D1 = $7.00 * (1 + 0.05) = $7.35.

The current trading price is $70.00, but we must account for the flotation costs of $2.75 per share.

This gives us an adjusted price P0* = P0 - FlotationCosts

= $70.00 - $2.75

= $67.25.

The cost of common equity (k) from new shares is then: k = (D1 / P0*) + g = ($7.35 / $67.25) + 0.05, which we need to solve.

k = ($7.35 / $67.25) + 0.05 = 0.1092 + 0.05 = 0.1592 or 15.92%

Therefore, the firm’s cost of common equity from issuing new shares is 15.92%.