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

Answer:

14.87%

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%