Question

Bay Beach Industries wants to maintain their capital structure of 40% debt and 60% equity. The firm's tax rate is 34%. The firm can issue the following securities to finance the investments: Bonds: Mortgage bonds can be issued at a pre-tax cost of 9 percent. Debentures can be issued at a pre-tax cost of 10.5 percent. Common Equity: Some retained earnings will be available for investment. In addition, new common stock can be issued at the market price of $46. Flotation costs will be $3 per share. The recent common stock dividend was $3.60. Dividends are expected to grow at 6% in the future. What is the cost of external equity?

Answer 1

The cost of external equity for Bay Beach Industries is 13.83%.

Step-by-step explanation:

The cost of external equity can be calculated by using the dividend growth model. In this case, we need to find the cost of new common stock that will maintain the desired capital structure of 60% equity. The cost of external equity can be represented as:

Cost of External Equity = (Dividend / Stock Price) + Growth rate

Given that the recent common stock dividend was $3.60 and the market price of the stock is $46, and assuming a dividend growth rate of 6%, the cost of external equity can be calculated as:

Cost of External Equity = (3.60 / 46) + 0.06 = 0.07826 + 0.06 = 0.13826 or 13.83%

Answer 2

14.87%

Step-by-step explanation:

The computation of the cost fo external equity is shown below:

Cost of external equity = {D1 ÷ P0 × (1 - f)} + g

where,

D0 represents the current dividend = $3.60

D1 represents Dividend for next year which is

= D0 × (1 + g)

= $3.60 × (1 + 0.06)

= $3.816

P0 represents the current price of the stock = $46

f represents flotation cost = $3

flotation cost =$3 per share

f = % of flotation cost which is

= ($3 ÷ $46 ) × 100

= 6.5217391%

g represents the growth rate = 6%

Now placing these values to the above formula

So,

Cost of external equity is

= {$3.816 ÷ $46 × (1 - 0.065)} + 0.06

= ($3.816 ÷ $43 ) + 0.06

= 0.148744 × 100

= 14.87%