Final answer:
The cost of external equity for Southern Corporation can be computed using the Gordon Growth Model after adjusting for flotation costs. The cost is the sum of the dividend yield (based on net proceeds from the share after flotation costs) plus the dividend growth rate.
Step-by-step explanation:
Calculating the Cost of External Equity
When Southern Corporation considers issuing new common stock to finance its capital investments, it must calculate the cost of external equity. The cost of external equity reflects the rate of return investors require for investing in the company's equity. For Southern Corporation, which has a stock market price of $78 and expects dividends to grow at 4% in the future, the Gordon Growth Model (also known as the Dividend Discount Model) is a suitable method to determine this cost.
The Gordon Growth Model is formulated as:
Cost of Equity = (Dividends per share / Current stock price) + Growth rate of dividends
However, when issuing new common stock, the company will incur flotation costs of $4 per share. This expense reduces the amount of capital that can be used from each new share issued. Thus, the actual price to be used in the model should reflect the net proceeds after paying flotation costs, which is $74 ($78 market price - $4 flotation cost).
The cost of external equity would be calculated using the adjusted market price:
Cost of External Equity = ($3.29 / $74) + 4%
By calculating this, investors can determine if the potential dividend payments and expected growth in stock value are sufficient to meet their required rate of return. If the cost of external equity is too high compared to other financing options or relative to the returns the company expects to generate from its new investments, the company may reconsider its financing strategy.
As Southern Corporation's dividend is $3.29 and its shares will be issued at a net price of $74, the cost of external equity can be found by adding the initial yield (dividend/price) to the growth rate.