Question

Garcia Ltd. is trying to estimate its cost of common equity, and it has the following information. The firm has a beta of 0.90, the before-tax cost of the firm's debt is 7.75%, and the firm estimates that the risk-free rate is 5% while the current market return is 13%. The firm pays dividends annually and expects dividends to grow at a constant rate of 5% indefinitely. The most recent dividend per share, paid yesterday, is $2.00. Currently, the firm's stock sells for $35.00 per share, but if the firm issues new shares, it will net $33.15 per share. Finally, the firm has a marginal tax rate of 34%. The cost of new common stock is ___________.

Answer 1

Cost of common stock = 11.33%

Step-by-step explanation:

The cost of common stock can be determined using the dividend valuation model.

According to the dividend valuation, the value of a stock is the present value of expected future dividends discounted at the required rate of return.

The model can me modified to determined the cost of equity having flotation cost as follows:

Cost of equity = D(1+r )/P(1-f) + g

d- dividend, p- price of stock , f - flotation cost , - g- growth rate

Cost of common stock =

D- 2.00, g- 5%, Price net flotation cost = $33.15

Ke = 2.00 × (1.05)/33.15) + 0.05 × 100

= 11.33%

Cost of common stock = 11.33%