Question

Southern Corporation has a capital structure of 40% debt and 60% common equity. This capital structure is expected not to change. The firm's tax rate is 34%. The firm can issue the following securities to finance capital investments: Debt: Capital can be raised through bank loans at a pretax cost of 8.5%. Also, bonds can be issued at a pretax cost of 10%. Common Stock: Retained earnings will be available for investment. In addition, new common stock can be issued at the market price of $59. Flotation costs will be $3 per share. The recent common stock dividend was $3.15. Dividends are expected to grow at 7% in the future. What is the cost of external equity?

Answer 1

The cost of external equity for Southern Corporation, calculated using the Gordon Growth Model, is 13.02% after accounting for dividends, growth rate, and flotation costs.

Step-by-step explanation:

To calculate the cost of external equity, we can use the Gordon Growth Model, which is represented by the formula Cost of Equity = (D1 / P0) + g, where D1 is the dividend expected next year, P0 is the current price of the stock, and g is the growth rate of the dividends. In this case, since the company can issue new common stock at $59 with flotation costs of $3, the net price received by the company (P0) would be $56 ($59 - $3). Given that the dividend is expected to grow at 7% (g), and the recent dividend was $3.15 (D0), we can calculate D1 as $3.15 * (1+0.07), which equals $3.3705. The cost of external equity can then be calculated as follows: ($3.3705 / $56) + 0.07 = 0.0601875 + 0.07 = 0.1301875 or 13.02% when converted to percentage form.