Question

Shamas famous restaurants expects to pay a common stock dividend of $1.50 per share next year (d1). dividends are expected to grow at a 4% rate for the foreseeable future. shamas’ common stock is selling for $18.50 per share and issuance costs are $3.50 per share. what is shamas cost of external equity?

Answer 1

The company's external equity comes from those funds raised from public issuance of shares or rights. The cost of external equity is the minimum rate of return which the shareholders supply new funds by purchasing new shares to prevent the decline of the market value of the shares. To compute the cost of external equity, we should use this formula: 

Ke = (DIV 1 / Po) + g 

Ke = cost of external equity 

DIV 1 = dividend to be paid next year 

Po = market price of share 

g = growth rate 

In the problem, the estimated dividend to be paid next year is $1.50. The market price is $18.50 and the growth rate is 4%. 

Substituting the given to the formulas, we need to divide $1.50 by $18.50 giving us the result of 8.11% plus the growth rate; this would yield to the result of 12.11% cost of external equity.