Suppose that Beach Blanket's common shares sell for $55 per share, are expected to set their next annual dividend at $3.00 per share, and that all future dividends are expected to grow by 8 percent per year, indefinitely. If Beach faces a flotation cost of 10 percent on new equity issues, what will be the flotation-adjusted cost of equity?
A) 5.45 percent
B) 8.06 percent
C) 13.45 percent
D) 14.06 percent

Question

Quizplus · Accepted Answer

The flotation-adjusted cost of equity can be calculated using the dividend discount model (DDM) adjusted for flotation costs. The formula for the cost of equity without flotation costs is given by $r = \frac{D_1}{P_0} + g$, where $r$ is the cost of equity, $D_1$ is the dividend next year, $P_0$ is the current price, and $g$ is the growth rate. Here, $D_1 = $3.00$, $P_0 = $55$, and $g = 8\%$. However, due to the 10% flotation cost, the effective price that the company receives is only 90% of $55, which is $P_0 \times (1 - 0.10) = $55 \times 0.90 = $49.50$. Using the adjusted price in the DDM formula gives us $r = \frac{3}{49.50} + 0.08 = 0.0606 + 0.08 = 14.06\%$.

Suppose That Beach Blanket's Common Shares Sell for $55 Per