Question Details

The Cost of Capital: Cost of New CommonStock

If a firm plans to issue new stock, flotation costs (investmentbankers' fees) should not be ignored. There are two approaches touse to account for flotation costs. The first approach is to addthe sum of flotation costs for the debt, preferred, and commonstock and add them to the initial investment cost. Because theinvestment cost is increased, the project's expected return isreduced so it may not meet the firm's hurdle rate for acceptance ofthe project. The second approach involves adjusting the cost ofcommon equity as follows:

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The difference between the flotation-adjusted cost of equity andthe cost of equity calculated without the flotation adjustmentrepresents the flotation cost adjustment.

Quantitative Problem: Barton Industries expectsnext year's annual dividend, D1, to be $1.80 and it expectsdividends to grow at a constant rate g = 4.9%. The firm's currentcommon stock price, P0, is $22.30. If it needs to issue new commonstock, the firm will encounter a 4.3% flotation cost, F. Assumethat the cost of equity calculated without the flotation adjustmentis 12% and the cost of old common equity is 11.5%. What is theflotation cost adjustment that must be added to its cost ofretained earnings? Round your answer to 2 decimal places. Do notround intermediate calculations.
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What is the cost of new common equity considering the estimatemade from the three estimation methodologies? Round your answer to2 decimal places. Do not round intermediate calculations.
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