Cost of new common equity also known as external capital equity is similar to the cost of retained earnings, except that it is higher than cost of retained earnings. This is because an extra cost known as flotation cost is also incurred in raising new equity, which reduces the net proceed for investment. Thus, cost of issuing new common stock is greater than the cost of retained earnings. Cost of new equity can be calculated by modifying the Discounted Cash Flow formula as below: r e = D 1 P 0 ( 1 − F ) + g Here, Dividend expected to be paid next year is “ D 1 ” Price of the stock today is “ P 0 ” Flotation cost expressed in percentage is “ F ” The company’s cost of retained earnings is 15.5 percent and currently sells its stock for $32. Its expected next dividend is $3.36 and flotation cost of new common equity is 6.5 percent.

Question

DEF Company's current share price is $17 and it is expected to pay a $1.55 dividend per share next year. After that, the firm's dividends are expected to grow at a rate of 2.7% per year. What is an estimate of DEF Company's cost of equity? DEF Company also has preferred stock outstanding that pays a $2.45 per share fixed dividend. If this stock is currently priced at $25.6 per share, what is DEF Company's cost of preferred stock?

Answer 1

Question

Chapter 11, Problem 11PROB

Summary Introduction

Cost of new common equity also known as external capital equity is similar to the cost of retained earnings, except that it is higher than cost of retained earnings. This is because an extra cost known as flotation cost is also incurred in raising new equity, which reduces the net proceed for investment. Thus, cost of issuing new common stock is greater than the cost of retained earnings.

Cost of new equity can be calculated by modifying the Discounted Cash Flow formula as below:

re=D1P0(1−F)+g

Here,

Dividend expected to be paid next year is “D1”

Price of the stock today is “P0”

Flotation cost expressed in percentage is “F”

The company’s cost of retained earnings is 15.5 percent and currently sells its stock for $32. Its expected next dividend is $3.36 and flotation cost of new common equity is 6.5 percent.

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