Question

Messman Manufacturing will issue common stock to the public for $50. The expected dividend and the growth in dividends are $3.50 per share and 5%, respectively. If the flotation cost is 10% of the issue's gross proceeds, what is the cost of external equity, re

Answer 1

The cost of external equity for Messman Manufacturing is 12.77%, calculated using the Gordon Growth Model and adjusting for the flotation cost.

Step-by-step explanation:

The cost of external equity, re, for Messman Manufacturing can be calculated using the Gordon Growth Model which takes into account the expected dividend, growth in dividends, and net proceeds after flotation cost. The formula for the cost of external equity is re = (D1 / P0) + g, where D1 is the expected dividend next year, P0 is the price at which the shares are sold after adjusting for flotation cost, and g is the growth rate of dividends.

To incorporate the flotation cost, we determine the net proceeds per share which is P0_net = P0 * (1 - FlotationCostRate). Then the cost of external equity can be recalculated with this adjusted price:

re = (D1 / P0_net) + g

In this case, D1 is $3.50, g is 5%, the flotation cost is 10%, and the initial price P0 is $50. After accounting for the flotation cost, P0_net is $50 * (1 - 0.10) = $45. The cost of external equity, re, is then computed as ($3.50 / $45) + 0.05 = 0.0777 + 0.05 = 0.1277, or 12.77%.